By Gerry Sullivan
Published in Financial News July 2007

New index funds weighted according to fundamental analysis have proliferated in the past several years. Many such funds use the words “financial revolution,” “groundbreaking,” and “a better way to index” in their marketing efforts. Yet these funds are not novel. In truth they all can be explained by well-known financial research known as the Three Factor Model. These new funds benefit from a “value bias” and once they have the three years of performance required to be categorized by Morningstar, they will fall in the “value” column.

To understand why these funds are not “revolutionary”, it helps to go back to the work of finance professors Eugene Fama of the University of Chicago Graduate School of Business and Kenneth R. French of the Tuck School of Business at Dartmouth College. Messrs. Fama and French improved the Capital Asset Pricing Model with their 1992 paper, “The Cross-Section of Expected Stock Returns” (Journal of Finance, June 1992). Their resulting Three Factor Model, as it is commonly known, demonstrated that in the long run, value stocks beat growth stocks and small-cap stocks outperform large-cap ones.

I can personally attest to the fact that these funds represent portfolios explained by the Three Factor Model. Ten years after attending the University of Chicago’s Graduate School of Business from 1984 to 1986 (while Fama and French were both on the faculty) and graduating with an M.B.A. in finance, I was challenged by a private family office to build a core equity portfolio model. Naturally I went back to the resources of the Chicago GSB and the findings of the Three Factor Model. My goal was to create a high quality large-cap core equity portfolio. I chose to focus on value vs. growth, believing that the portfolio would benefit from the value bias if, instead of market capitalization, it was weighted by fundamental inputs. I started with book value and considered other fundamental inputs like net revenue, EBITDA, and total assets.

For the period 1987 through 1997, the prominent large value indexes at the time (the Russell 1000 Value and S&P BARRA Value) underperformed the S&P 500. I hypothesized that a fundamentally weighted large-cap value portfolio would be able to close the gap with the S&P 500 (during the same period) by capturing the movement of book value instead of the movement of market value.

In 1997, I created the Industry Leaders Portfolio Strategy. The model’s first incarnation used common shareholders’ equity as the fundamental weighting. It significantly beat the two large value indexes over the period from 1987 through 1997. Then, in March 1999, using this strategy, the Industry Leaders Fund was launched, the first “fundamentally weighted” investment product. A credit screen was added in 2001 to refine the quality of the portfolio, and its intraday performance was captured live on the Bloomberg Professional Service in 2002 under the ticker ILEADERS <index>. In 2006, the U.S. Patent Office awarded a patent on the allocation and selection process employed by the Portfolio Strategy.

In 2005, eight years after the creation of the Industry Leaders Portfolio Strategy,  “fundamentally weighted” index funds began to appear. This raises a question: Have the newfangled “fundamentally weighted” index funds miraculously captured a mispricing in the market, dispelling the “efficient market theory?” The answer is clearly no. Rather, the self-proclaimed brilliance behind these funds is simply the result of value stocks outperforming growth stocks over the long term. More specifically, this “brilliance” benefits from hindsight, as the funds are largely marketed based on back-tested data which shows, to no investment professional’s surprise, that value beat growth over the long term. Over the past 20-plus years, today’s prominent value indexes (the Russell 2000 Value and Russell 1000 Value) beat the S&P 500.

Psychologist/Philosopher William James once said, “The art of being wise is in the art of knowing what to overlook.” Clearly, the work of Fama and French showed the advantages of value over growth investing long before today’s “fundamentally weighted” index funds were created with the benefit of these research findings. For the creators of these funds to claim they are based on a groundbreaking or revolutionary approach to index investing is disingenuous.

Gerry Sullivan is the Chief Investment Officer of the Industry Leaders® Fund.