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Fundamental indexing starts from the observation that in a value-weighted
portfolio, any overpricing affects the stock’s portfolio weight
upward and its typical return downward, and vice versa; but on average
the ‘drag’ on the portfolio’s expected return caused by this negative
interaction is avoided if weights are based instead on accounting-based
instruments for true value. We find that the drag effect is statistically
and economically unimportant. Our empirical work avoids regression-based
alphas, which are flawed by demonstrable instabilities in the
exposures.
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