The Fundamental Index® methodology was developed to address the structural return drag created by traditional capitalization-based indexing strategies, which systematically overweight overpriced securities and underweight underpriced securities. According to our research, the return drag associated with this structural flaw is 2% to 3% per annum.

The return drag of capitalization-weighted indexes is caused by the linkage between a company’s stock price and its weight in the index—that is, a company whose stock price is overvalued (undervalued) will have too high (low) a weight in the index, causing it to underperform (outperform) as the stock price corrects.

In a perfectly efficient market, where stock prices are always accurate measures of a firm’s future value, capitalization would be an acceptable way to weight stocks in an index. If, on the other hand, prices are not perfect measures of a firm’s future value, capitalization-weighted indexes will experience a return drag from holding too much of an overvalued stock and too little of an undervalued stock.

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