Empirical Examination of Fundamental Indexation in the German Market

Abstract

Index Funds, Exchange Traded Funds and Derivatives give investors easy access to well diversified index portfolios. These index-based investment products exhibit low fees, which make them an attractive alternative to actively managed funds. Against this background, a new class of stock indices has been established based on the concept of “Fundamental Indexation”. The selection and weighting of index constituents is conducted by means of fundamental criteria like total assets, book value or number of employees. This paper examines the performance of fundamental indices in the German equity market. For this purpose, a backtest of five fundamental indices is conducted over the last 20 years. Furthermore the index returns are analysed under the assumption of an efficient as well as an inefficient market. Index returns in efficient markets are explained by applying the three factor model for stock returns of Fama and French (J Financ Econ 33(1):3–56, 1993). The results show that the outperformance of fundamental indices is partly due to a higher risk exposure, particularly to companies with a low price to book ratio. By relaxing the assumption of market efficiency, a return drag of capitalisation weighted indices can be deduced. Given a mean-reverting movement of prices, a direct connection between market capitalisation and index weighting leads to inferior returns.