Fundamentally Better: The case for Revenue-Weighting
As we search for the most effective fundamental metric or combination of metrics, it pays to ask the question: what are we looking for? Are we looking for the highest possible return? The largest Sharpe value? A defensive portfolio with the lowest overall volatility?
All of those are worthy goals, but selecting a theory based on those goals raises the issues common to back tested results. While a given fundamental metric might score well on a historical basis, it is far too easy to confuse correlation with causality, and the positive excess returns could be a historical artifact driven by noise rather than reason. Past performance, as we all know, is no predictor of future results.
Instead, what we should be looking for in a fundamental index is a step-wise improvement on traditional indexing: a way to capture the best aspects of cap-weighted indexes, while avoiding the worst. In this context, the case is clear. The positive aspects of indexing that we want to preserve include:
Transparency
Broad representation and diversification
Low transaction costs and minimal account turnover
Removal of emotion from the investing process
Freedom from manipulation and corporate malfeasance
Meanwhile, the chief problem with cap-weighted indexes is their tendency to overweight overvalued stocks while under weighting undervalued stocks. This can cause the indexes to get caught up in stock market bubbles, as happened during the late-1990s, leading to painful investors losses and decreased long-haul performance.
VTL Associates believes that Revenues are the most effective fundamental by which to weight any well-known index.
