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An Empirical Analysis of Fundamental Indexation

By David Garver

The Capital Asset Pricing Model (CAPM) and the case for efficient market equity pricing has been dealt a series of blows over the last twenty years. The recent emergence (Arnott, Hsu & Moore, 2005) of a set of strategies that purport to beat the capitalization weighted market portfolio suggested by the efficient market hypothesis, using price insensitive valuation techniques (book value, total employment, and trailing five year averages of gross cash flow, revenue, sales and dividends) raises yet another strong challenge to financial dogma. This paper examines whether ETFs that track these ‘fundamental indexes’ experience superior risk adjusted performance on the CAPM and Fama-French Three Factor model relative to capitalization weighting or other ‘outperforming’ indexation strategies. The paper finds that over the period of June 2006 to March 2008, of the twelve domestic fundamental ETFs examined, only the Earnings 500 ETF consistently performed above the benchmarks. While the performance of large-cap and total market fundamental ETFs lend some strength to the argument for fundamental indexation, they underwhelm given fundamental indexation’s historical outperformance and undermine the claim that equity prices are, and will continue to be, significantly mistaken given the information inherent in firm fundamentals.

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Advisor: Edward Tower

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