Exploration On Fundamental Indexation In Chinese Stock Market

Capitalization weighted indices have been widely used till now. However, the“return drag” in this kind of index occurs because cap-weights are too large or smallfor overpriced or underpriced stocks. Under noisy market hypothesis, capitalizationweighted indexation is proved to be suboptimal. Since2005when Arnott firstproposed new market indices based on firms’ fundamental size estimated byaccounting metrics, the so-called fundamental indexation has been widely studied andtested in different markets in order to find an indexation better off the conventionalcap-weighted indices and substitute it as a more appropriate approximation of “marketportfolio”. Basically, constitution for fundamental indices is under the thought ofestimating the fundamental weights instead of fundamental value.In our study, based on theoretical support, we conduct mainly two ways offundamental indexation in China A-share market. One is to pick and weight stocks forindices according to accounting metrics, namely book value, sales, operating cashflow, and gross dividend for all A share and smoothed capitalization. The other isaccording to smoothed capitalization weights with different bandwidths in time.We evaluate fundamental indices by comparison with the conventionalcapitalization weighted indices in profitability, mean-variance efficiency androbustness and discuss the source of excess return if there is any in fundamentalindices by testing in Fama-French three factor model.Our empirical study results show that in Chinese A-share market, fundamentalindices via smoothed capitalization outpace capitalization weighted indices in ourtesting period from2005to2011with better performance in larger bandwidth;however, since the poor performance of most fundamental indices via accountingmetrics, this kind of fundamental indexation may not work for China.