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STANDUP Advice: Fundamental Indexing

John J. De Goey, CFP
0 Comments|August 31, 2007

New passive investments with unbundled fee structure are a step in the right direction.
New passive investments with unbundled fee structure are a step in the right direction.

Most people have come to recognize that passive investment products are by no means homogeneous. The core belief of all passive investments is that markets are highly efficient. Note that markets needn't be totally efficient for passive products to work. All that's required is that markets be sufficiently efficient that it would be considered improbable to reliably outperform them using fundamental and technical analysis. That's where opinions begin to differ. There are a few variations on how to build a better passive investment product.

The standard way is to buy a basket of market weighted securities that are considered to be a reasonable proxy for "the market." This method is probably most appropriate for people who want to keep costs as low as possible and who want to track widely-cited investable benchmarks in their investing.

A second method might be called "equilibrium investing." This is the method that uses scientific research to show that there are dimensions of risk and reward. Proponents correspondingly use investment products that aim to efficiently capture the return premia that are associated with higher degrees of risk (e.g. value stocks and small company stocks).

Over the past few years, a third method has gained a strong following in the investment community. It is known as fundamental indexing. Like equilibrium investing, fundamental indexing aims to improve on the limitations of a naive market-weighted index. By focusing on a few fundamental factors, researchers have shown how they can place less emphasis on overvalued securities, calculate fair values based on fundamentals, limit volatility and reduce the impact of stock market bubbles.

The fundamental factors used include: book value, dividends, cash flow, earnings and sales- all things that are less likely to be mispriced in the first place. In the past couple of years, two companies have set up shop to bring fundamental-index type products to Canada. The first company was Claymore, on the ETF side. The most recent entrant is Pro-Financial, a company that holds the exclusive distribution rights for fundamental index products in Canada.

With headquarters in Oakville, Ontario, Pro-Financial has released a number of low-cost mutual funds based on the principles of fundamental indexing. It is their mission to bring fundamental indexing into the mainstream in Canada. To date, research seems to suggest that returns are higher and volatility lower than for products using the traditional capitalization-weighted index approach. For more information on the company and its process, please visit

Compared to conventional index products, MERs (management expense ratios) are slightly higher. Compared to standard mutual funds (the real target), MERs are decidedly lower. The real opportunity here is for investors to switch out of high cost, actively managed mutual funds into lower cost fundamental index products. The kicker is that Pro-Financial's mutual funds are available in both a bundled (i.e. trailing commission included) and unbundled format. To my mind, this is a crucial wrinkle.

Research the world over has shown that advisors have compensation-related biases. In other words, advisors might resist recommending superior products because they do not have an embedded compensation component. Many "old school" advisors are notoriously reticent to give their clients a direct bill, preferring to perpetuate the myth that professional financial advice is free.

The revolution has begun. It might take a generation or more, but there is no doubt in my mind that more sensible investment products are soon to be embraced by a wide swath of the general population.

John J. De Goey, CFP is a Senior Financial Advisor with Burgeonvest Securities Limited (BSL) and author of The Professional Financial Advisor II. The views expressed are not necessarily shared by BSL.

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