FNDX: A Value Investor's Assessment of a Fundamental Index ETF

For the disciplined investor, the core tenet is a margin of safety-a buffer between a stock's price and its intrinsic value. The traditional market-cap-weighted index, however, often undermines this principle. It weights companies by their stock price, which means a company's valuation can become its own weight. This creates a perverse incentive: the more overvalued a giant company becomes, the more it dominates the index. The Fundamental Index approach, pioneered by Research Affiliates, was born from a desire to correct this flaw.

The strategy's origin is instructive. It emerged in the aftermath of the tech bubble's collapse and the financial crisis, events that starkly revealed the dangers of a price-driven market. When stock prices for tech companies soared in the 1990s, the market overweighted them until the crash. The same speculative excess was evident again in the years leading up to the 2008 crisis. In response, the firm was founded to develop an alternative indexing strategy that would break the link between price and weight. Born out of economic crisis, the approach was built on contrarian investing principles, selecting and weighting stocks based on objective financial measures of company size rather than their market price.

This is the essence of the value investor's lens. Instead of weighting by price, Fundamental Indexing weights by economic size-using metrics like sales, cash flow, and dividends. The goal is to achieve a better entry point by avoiding the price-driven overvaluation that plagues traditional indices. By focusing on the scale of the underlying business, the strategy aims to target a wider competitive moat. It seeks companies that are large and fundamental in their operations, not just in their market cap. This approach has historically shown a bias toward securities that are inexpensive relative to their earnings, which may make it particularly well-suited for value-driven market conditions.

The practical effect is a more balanced portfolio. Fundamental Indexes tend to have reduced exposure to those same stocks, including the Magnificent Seven, compared to the S&P 500. This diversification goes beyond simple stock selection; it changes the very weighting exposure, distributing capital more evenly across the economic footprint of the market. For the patient investor, this represents a disciplined way to participate in the market's growth while systematically seeking a margin of safety that the price-weighted index often fails to provide.

Portfolio Composition and the Value Benchmark Comparison

The fund's holdings reveal a portfolio of large, established companies, but their prominence is determined by economic scale, not market price. The top ten holdings, including Apple, Microsoft, and Exxon, are giants in their own right. Yet their weights in FNDX are capped at around 4%, 3%, and 2% respectively, a deliberate constraint that prevents any single stock from dominating the index. This is the core of the Fundamental Index approach: it systematically underweights companies that have become overvalued simply because their stock prices have soared, even if their underlying business size remains unchanged.

Compared to a traditional value benchmark, this creates a different kind of portfolio. The Morningstar Large Value category, for instance, has delivered a 1-year annualized return of 14.74%, lagging behind FNDX's 17.26%. This outperformance suggests the strategy's focus on fundamental size may have captured a different, perhaps more resilient, segment of the market. However, the trade-off is in the mechanics of the fund itself. Strategic beta products like FNDX typically have larger turnover and tracking error compared to a passive cap-weighted benchmark. This is because the index is rebalanced based on fundamental metrics, which can change more frequently than market cap, leading to more buying and selling.

The cost structure reflects this active management. FNDX carries a higher expense ratio than a typical market-cap ETF, though it is lower than the industry average for strategic beta funds. For the value investor, this is a cost of admission for a different philosophy. It is the price paid for a portfolio that aims to avoid the price-driven overvaluation that can plague traditional indices, even if it means a slightly higher fee and more frequent trading. The bottom line is that FNDX offers a familiar set of large-cap stocks but through a different lens-one that weights by economic reality rather than market sentiment.

Long-Term Compounding and the Value Investor's Horizon

For the value investor, the ultimate test is not a single quarter's return, but the power to compound wealth over decades. FNDX has demonstrated a solid track record on that front. The fund has delivered annualized returns of 14.99% over the past five years and 14.38% over ten years. Its recent momentum is clear, with a 1-year return of 17.26% that matches the performance of its underlying index, indicating the fund is effectively tracking its benchmark.

This historical compounding power is a key consideration. The strategy's focus on fundamental size has, over the long term, produced results that have outpaced a traditional value category. However, the path to compounding is not without friction. The fund's higher costs and larger turnover compared to a passive cap-weighted benchmark represent a persistent drag. These expenses are not a one-time fee but a recurring cost that eats into returns year after year.

Viewed through a long-term lens, this is the central trade-off. The strategy aims to buy businesses at a better entry point by avoiding price-driven overvaluation, which may support a wider moat. Yet, the higher fees and more active management required to maintain that approach can erode gains over very long horizons. The value investor must weigh the potential for a better starting point against the ongoing cost of ownership. For a patient capital allocator, the question is whether the fund's historical compounding power-its ability to grow a dollar into more dollars over time-can sufficiently overcome these structural costs to deliver a superior final outcome.

Catalysts, Risks, and Portfolio Allocation for Value Investors

The FNDX thesis rests on a simple, contrarian bet: that markets will eventually correct for the price-driven overvaluation that can plague traditional indices. The primary catalyst for the fund's outperformance would be a market environment that favors value and economic reality over speculative growth. This could manifest as a broad correction or a rotation away from the most overvalued growth stocks, where the fundamental approach's historical bias toward inexpensive securities may shine. In such a scenario, the strategy's systematic underweighting of price-driven giants could translate into a material advantage.

The key risk, however, is that the strategy's higher costs and operational friction fail to generate sufficient outperformance to justify the expense. Strategic beta products like FNDX are built on a different premise than passive cap-weighting, and that difference comes with a price. As noted, these funds will generally have larger turnover, tracking error and higher fees relative to a market-cap benchmark. For the value investor, this is the central question: does the potential for a better entry point and a more balanced portfolio outweigh the persistent drag of these costs over a full market cycle?

For investors considering a position, the advice is to monitor the fund's performance against its costs and its benchmark over time. The goal is to see if the strategy's compounding power can overcome the structural headwinds of higher fees and more active management. Tools like the fee impact simulator can help quantify the long-term erosion of returns from those higher expenses. The bottom line is that FNDX offers a disciplined, value-oriented alternative to traditional indexing, but its success depends on the market eventually rewarding economic size over market price. For the patient capital allocator, it's a bet on the long-term reversion of market sentiment.