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New Paradigms in Stock Market Indexing


  • Derek Jun
  • Burton G. Malkiel


"Considerable recent interest has been shown in a new set of stock-market indices that are weighted by fundamental factors such as sales, earnings, dividends or book values, rather than by capitalization. In this paper, we analyze the performance of Fundamental Indexing™ ("FI"). First, we show that the source of FI's recent excellent performance is not from its ability to systematically arbitrage mispricing in a noisy market but from increasing the portfolio's exposure to stocks with low price-to-book values and with small capitalizations. We find that FI does not produce a positive alpha when its excess returns are explained by the Fama-French three-factor model of CAPM beta, the value premium and the size premium. Second, we show that it is possible to construct a portfolio of exchange-traded funds with similar factor loadings that can replicate, and sometimes, even outperform FI. However, we caution investors not to expect consistent outperformance from portfolios tilted towards value and small-cap stocks. Historical data shows evidence of mean reversion in the performance of such strategies." Copyright 2007 The Authors Journal compilation (c) 2007 Blackwell Publishing Ltd.

Suggested Citation

  • Derek Jun & Burton G. Malkiel, 2008. "New Paradigms in Stock Market Indexing," European Financial Management, European Financial Management Association, vol. 14(1), pages 118-126.
  • Handle: RePEc:bla:eufman:v:14:y:2008:i:1:p:118-126

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    References listed on IDEAS

    1. Blomeyer, Edward C. & Johnson, Herb, 1988. "An Empirical Examination of the Pricing of American Put Options," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 23(01), pages 13-22, March.
    2. Sterk, William, 1982. " Tests of Two Models for Valuing Call Options on Stocks with Dividends," Journal of Finance, American Finance Association, vol. 37(5), pages 1229-1237, December.
    3. Chen, K C & Sears, R Stephen & Shahrokhi, Manuchehr, 1992. "Pricing Nikkei Put Warrants: Some Empirical Evidence," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 15(3), pages 231-251, Fall.
    4. Whaley, Robert E., 1982. "Valuation of American call options on dividend-paying stocks : Empirical tests," Journal of Financial Economics, Elsevier, vol. 10(1), pages 29-58, March.
    5. Evnine, Jeremy & Rudd, Andrew, 1985. " Index Options: The Early Evidence," Journal of Finance, American Finance Association, vol. 40(3), pages 743-756, July.
    6. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters,in: Theory Of Valuation, chapter 8, pages 229-288 World Scientific Publishing Co. Pte. Ltd..
    7. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166.
    8. K. C. Chen & R. Stephen Sears & Manuchehr Shahrokhi, 1992. "Pricing Nikkei Put Warrants: Some Empirical Evidence," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 15(3), pages 231-251, September.
    9. Schulz, G. Uwe & Trautmann, Siegfried, 1994. "Robustness of option-like warrant valuation," Journal of Banking & Finance, Elsevier, vol. 18(5), pages 841-859, October.
    10. Veld, C.H., 1994. "Warrant pricing : A review of empirical research," Discussion Paper 1994-34, Tilburg University, Center for Economic Research.
    11. Barone-Adesi, Giovanni & Whaley, Robert E, 1987. " Efficient Analytic Approximation of American Option Values," Journal of Finance, American Finance Association, vol. 42(2), pages 301-320, June.
    12. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    13. Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 5-59.
    14. Bodurtha, James N. & Courtadon, Georges R., 1987. "Tests of an American Option Pricing Model on the Foreign Currency Options Market," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 22(02), pages 153-167, June.
    15. Chesney, Marc & Scott, Louis, 1989. "Pricing European Currency Options: A Comparison of the Modified Black-Scholes Model and a Random Variance Model," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 24(03), pages 267-284, September.
    16. Leonard, David C & Solt, Michael E, 1990. "On Using the Black-Scholes Model to Value Warrants," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 13(2), pages 81-92, Summer.
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    Cited by:

    1. Walkshäusl, Christian & Lobe, Sebastian, 2010. "Fundamental indexing around the world," Review of Financial Economics, Elsevier, vol. 19(3), pages 117-127, August.
    2. repec:eee:finana:v:51:y:2017:i:c:p:1-15 is not listed on IDEAS
    3. Burton G. Malkiel & Derek Jun, 2009. "The Value Effect and the Market For Chinese Stocks," Working Papers 1177, Princeton University, Department of Economics, Center for Economic Policy Studies..
    4. Malkiel, Burton & Jun, Derek, 2009. "The "value" effect and the market for Chinese stocks," Emerging Markets Review, Elsevier, vol. 10(4), pages 227-241, December.
    5. Brigette Forbes & Anup Basu, 2011. "Does Fundamental Indexation Lead to Better Risk Adjusted Returns? New Evidence from Australian Securities Exchange," School of Economics and Finance Discussion Papers and Working Papers Series 275, School of Economics and Finance, Queensland University of Technology.
    6. repec:pri:cepsud:188malkiel is not listed on IDEAS

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