Towers Watson has started recommending its clients invest up to half of their passive assets in fundamental indices.
Senior investment consultant Philip Tindall says the firm believes traditional market cap indexes overweight overvalued securities and do not provide enough exposure to undervalued securities.
He says the firm does not think all of a pensions fund's passive portfolio should be market cap weighted. He adds: "This won't reduce risk. What we think it will do is enhance returns without increasing risk."
The strategy uses a range of fundamental factors, including 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 31 December.
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 says the firm has not been recommending the indexing strategy to their clients.
He says: "We don't think it's fundamentally flawed, but we don't feel it has any fewer weaknesses than the traditional market cap approach."
Currell says one concern is that by focusing on four fundamentals, investors could be missing out on other growth factors that could affect returns.
He asks "why go active" and says: "Fundamental indexing has more in common with low-risk, quant-based active management rather than being a passive strategy."
He adds: "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 this, saying fundamental indexing ticks all the boxes of a passive strategy - noting 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 adds the turnover within the strategy is also low, though not as low as with a market cap weighted index.
He also responds to criticisms that 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," says Tindall.
He adds: "We believe the approach is a sensible one. We can get some value-added for very low fees."
Tindall says Towers Watson's clients are still considering the firm's suggestion. He adds: "While we believe the theory works, it's still a big step for clients to go fully fundamental."
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