Fundamental indexation and mean reversion on the Taiwanese equity market
The equity market has a long memory of indexing. The market portfolio is a capweighted index that weights stocks based on the market capitalisation of the stocks constituting the index and has been upheld by modern portfolio theory as the optimal portfolio, generating the highest return for given risk. Justification for the meanvariance efficiency of the market portfolio stems from the assumed efficiency of stock markets. However, Siegel (2006) states that, because of speculative trading in the market, which induces noise in stock prices, the prices of stocks deviate from their intrinsic value. The subsequent reversal of overweighting of overvalued stocks and underweighting of undervalued stocks to their intrinsic values by capitalisation weighting results in a return drag. Recent observations of portfolios constructed based on weighting methodologies other than capitalisation weighting have resulted in portfolios that generate excess riskadjusted returns over and above that of the market portfolio; casting doubt on the assumed efficiency of the market. One such weighting methodologies is fundamental indexation, under which stocks are weighted by their fundamental metrics of size. The concept was introduced by Arnott, Hsu and Moore (2005). Chen, Chen and Bassett (2007) also introduced the concept of smoothed cap weights (SCW) as a more reliable estimate of the intrinsic value of a stock. This research study applies the concept of fundamental indexation and SCW to investigate the relative performance of fundamental indices of different concentrations (top 50 and mid-100 stocks) against cap-weighted portfolios on the Taiwanese equity market. The research period runs from January 2001 to June 2014, using the TEJ database as the data source. The TAIEX is employed as the market proxy. The research also examines the performance attribution and robustness of fundamental indices against cap-weighted portfolios. The results indicate that most fundamental indices constructed from the top 50 stocks are less mean-variance efficient than the TAIEX but more mean-variance efficient than the cap-weighted reference portfolio. All fundamental indices of the mid-100 stocks are more mean-variance efficient than the TAIEX and the reference portfolio. The return drag observed in the cap-weighted TAIEX and reference portfolio evidences the presence of mean reversion of stocks. Moreover, the returns of fundamental indices of the top 50 stocks are partly influenced by size risk premium but the fundamental indices comprised of the mid-100 stocks display return variations with statistically significant factor loading on the small cap (size) risk premium and value risk premium. Fundamental indices, on average show a higher resilience against the cap-weighted portfolios in both bull and bear markets. The sales index and fundamental composite index are the most mean-variance efficient fundamental indices and generate statistically significant alphas post accounting for both size and value risk premia.