For those investors who (unlike me) can’t afford to do fundamental analysis on a large number of companies (and if you can’t afford to analyze thousands of companies, you’re probably using a questionable method to select which ones to analyze), there’s a new class of ETFs which sounds like fixes some of the worst problems with typical stock funds.
Most people invest in funds that are based on a capitalization weighted index, which means that any time there’s a bubble affecting some of the stocks in the index, the fund is buying those stocks at the peak. The more popular those funds are, the easier it is to create bubbles in the stocks they buy.
There’s a new ETF (symbol PRF) that weights its holdings on dividends instead, which will sell stocks that are affected by bubbles (except in the unusual case where the company increases its dividend in step with the bubble).
The Political Calculations blog mentions similar strategies which appear to work about as well (the dividend weighting selects against small immature companies, and it ought to be possible to avoid that).
Weighting on revenues sounds like it works well, although it overweights retailers and underweights successful pharmaceutical companies and oil producers that find cheap sources of oil.
Weighting on the number of employees should work (although that underweights companies that outsource).
I’m somewhat partial to weighting on book value, but instead of the standard book value, I’d use tangible book value plus an estimate of amortized R&D expenses.
Shorting the 5 or 10 companies with the largest market capitalizations would probably be a good way to invest a modest portion of a portfolio in a way that would reduce risk and improve returns.
These strategies do have the potential to underperform if they becomes as popular as buying and holding S&P 500 funds was around 2000, but it will take some time to become that trendy, and even if it does there will probably still be funds using unpopular versions of fundamental weighting that will remain good investments.
One comment on “How to Weight Holdings in Stock Funds”
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Theory is missing from the data-centered analysis of fundamental indexation.
Analysis of the problems with dividends and certain other so-called fundamental metrics for either selecting stocks or weighting stocks in a portfolio can be found online. There are links at numeraire.com/download.htm to documents about this topic.
To facilitate fair, open discussion about this matter among interested persons, one of the linked documents includes comments by bloggers. I trust this conforms to fair use pursuant to The Chicago Manual of Style, 14/e.