Towers Watson touts fundamental to clients

Officials at the firm believe traditional market-cap indexes overweight overvalued securities, and don't provide enough exposure to undervalued-securities, said senior investment consultant Philip Tindall.

"We don't think all of it should be market-cap weighted," he said of pension fund's passive portfolios. "This won't reduce risk. What we think it will do is enhance returns without increasing risk," he added.

The strategy uses a range of fundamental factors - sales, profits, book value and dividends - to pick stocks.

The fundamental FTSE RAFI All World index beat the market-cap weighted FTSE All World index on an annualised basis in the one, three, five and ten year periods ending December 31. The fundamental index returned 46.6% versus 36.2% in the one-year period; -1% versus -3.7% in the three-year and 7.1% versus 4.1% in the five year periods.

Over the past ten years, the fundamental index was up 7.8%, 640 basis points better than the market-cap weighted index.

Investors like the Merseyside Pension Fund and the California Public Employees' Retirement System have already incorporated investment strategy indexes into their portfolios, but other industry experts are holding back.

Hewitt Associates principal Tim Currell said the firm has not been recommending the indexing strategy to their clients.

"We don't think it's fundamentally flawed, but we don't feel it has any fewer weaknesses than the traditional market-cap approach," said Currell.

He said one concern is that by focusing on four fundamentals, investors could be missing out on other growth factors that could affect returns.

"Why not go active," asked Currell. "Fundamental indexing has more in common with low-risk, quant-based active management rather than being a passive strategy. That is not, of itself, a bad thing - we prefer active management of equities to passive because we think there are real opportunities to add value even after fees. But schemes shouldn't confuse fundamental indexing with passive."

Tindall counters fundamental indexing ticks all the boxes of a passive strategy: it covers the entire market, employs a mechanical way of rebalancing that does not depend on security analysis, is low cost and has a high capacity.

Tindall added that the turnover within the strategy is also low, though not as low as with a market-cap weighted index.

Opponents also say the strategy has too much of a value tilt.

"We recognise there's a value element to this strategy, but it's not a constant value strategy. It has done very well over time," said Tindall.

He added: "We believe the approach is a sensible one. We can get some value-added for very low fees."

Tindall said Towers Watson's clients are still considering the firm's suggestion.

"Whilst we believe the theory works, it's still a big step for clients to go fully fundamental," said Tindall.