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An alternative fundamental weighting scheme based on enterprise value multiple

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Abstract

Fundamental indexing has been proposed as a semi-active strategy that outperforms classical market-capitalization weighting. This paper proposes an alternative weighting scheme based on the enterprise value multiple (EM) that integrates the market value of equity with debt information. Over the period 1972–2017, the EM-weighted index has lower tracking error and a higher information ratio when compared with a composite fundamental index in US equities. The EM index generates an information ratio of 0.71 which is larger than the composite fundamental index. The EM index also generates significant alpha that exceeds the traditional fundamental index using several asset pricing models. Further tests show that debt information plays an important role in the outperformance of the alternative weighting scheme.

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Notes

  1. To obtain a value tilt as in traditional fundamental indices, we use the inverse of the EM to construct portfolio weights. Details are provided in “Data and methodology” section.

  2. Obviously cap-weighted indexes reflect stocks’ relative prices.

  3. Interestingly, our EM weights produce similar alphas as Loughran and Wellman (2011) in the four-factor (Fama and French 1992, 1993; Carhart 1997) model. However, our portfolios are long only versus Loughran and Wellman’s (2011) long-short zero investment portfolios. The long only approach is likely much more cost efficient.

  4. Prior to 1972, fewer than 1000 publicly traded US firms traded on a consistent basis.

  5. Note that the average annualized excess return is not equal to the difference between the annual geometric returns by construction.

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Authors and Affiliations

  1. Western Connecticut State University, Danbury, USA

    Wenguang Lin

  2. Louisiana State University, Baton Rouge, USA

    Gary C. Sanger

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  1. Wenguang Lin
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  2. Gary C. Sanger
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Correspondence to Wenguang Lin.

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Lin, W., Sanger, G.C. An alternative fundamental weighting scheme based on enterprise value multiple. J Asset Manag 20, 146–156 (2019). https://doi.org/10.1057/s41260-019-00112-w

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