The application of fundamental indexing to the South African equity market for historical data dating back to 1996

Measuring the performance of any financial portfolio is only relevant ifcompared relative to another similar portfolio. Over the years the norm in theindustry has been to use market capitalisation indices as benchmarks tomeasure performance.Market capitalisation indices, such as the FTSE/JSE ALSI, create a naturalreturn drag because of the overweighting of overvalued stocks and theunderweighting of undervalued stocks. It is this return drag that led to thecreation of the Fundamental Indexing concept by Research Affiliates in 2005.Fundamental Indexing weights stocks based on their economic footprint in themarket rather than their market capitalisation. The Fundamental Indexingapproach uses four metrics, namely sales, book values, dividends and cashflows to calculate this economic footprint. The Fundamental Index is referredto as the RAFI (Research Affiliates Fundamental Index) IndexThe Fundamental Index concept delivered very good results when applied tothe South African stock market. The South African RAFI Composite Indexoutperformed the FTSE/JSE All Share Index by 5.55% p.a. compoundedannually during the period 1995 to 2006. This return was achieved with asimilar risk profile as the FTSE/JSE All Share Index. This index also hadsimilar turnover rates relative to the FTSE/JSE All Share Index. The SouthAfrican RAFI Composite Index also outperformed the FTSE/JSE All ShareIndex by 5.48% p.a. compounded during the measurement period wheninvestment income is included.The Fundamental Index outperformance clearly disproves the efficient markethypothesis. According to modern portfolio theory it is impossible to earnabnormal profits in excess of a market capitalisation index. The success ofFundamental Indices proves that market capitalisation indices are not optimaland deliver sub-optimal returns. Specifically, it can be seen that the SouthAfrican market is inefficient and that the FTSE/JSE All Share Index is not thebest tool for measuring the performance of the financial markets in SouthAfrica.