The work of Arnott et al. (2005) presented an interesting fact that the fundamentally-weighted indices generally outperform the market capitalisation-weighted counterparts in the US stock market. The research results prompted the introduction of fundamentally-weighted indices in the US market. Since research dealing with Croatian capital market also points out the inefficiency of the risk return trade-off of the cap-weighted (CROBEX) index this paper examines more closely the risk return characteristics of the potential fundamentally-weighted alternative and analyses the source of higher returns in the case of fundamentally-weighted indices. We use the original and propose a modified Fama French three factor model in order to try to capture specific sources of risk in the small and illiquid market. We find evidence in support of the view that better risk return trade-off of the fundamentally-weighted indices is driven by additional exposure to risk factors in comparison to CROBEX index.
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