Consuelo Mack met with Research Affiliates Chairman and CEO Rob Arnott and the week’s Financial Thought Leader on her Wealthtrack show and sought answers to two very important questions:

  • Why should we settle for just the market’s ‘average’ results provided by the index funds?
  • Is the capitalization weighted method used by the index funds efficient enough?

John Bogle’s 1975 innovation of the index fund, a vehicle that made the broad market available to the common investor at a cheaper cost, initially met with indifference from investors and derision on Wall Street. However, the merits of the index fund started becoming apparent to investors around 1986, and in the decades since it has become one of the most popular avenues for investment across America.

As a share of total equity fund assets, equity index funds (including ETFs) are almost a third, rising from nothing in 1976 to $2.7 trillion in 2013.

index fund Arnott

Yet, these funds earn only the return generated by the index.

Consuelo’s concern: can’t the investors do better than just ‘average?’

Consuelo put her second question in perspective with reference to the tech bubble that led to higher and higher weighting by capitalization in the indices as the prices of tech stocks climbed.

Investors paid dearly for this bias in the index when the tech bubble burst.

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Consuelo’s concern: is there a better method than weightage by capitalization?

In short: is there a better mousetrap?

Robert Arnott is chairman and CEO of Research Affiliates, LLC, “a research intensive asset management firm that focuses on innovative products” and founded in 2002.

The firm is known to be a pioneer of the concept of Tactical Asset Allocation and the RAFI Fundamental Index.

Arnott’s concept of Fundamental Index assigns weights in a portfolio on the basis of fundamental metrics such as sales, dividends, cash flow and book value, rather than market capitalisation weighting as is the current practice.

The Achille’s heel of the market capitalization method, according to Arnott, is that overpriced stocks tend to get higher weightage in the portfolio, and conversely, under-priced stocks get lower exposure.

“Why do we use this method of capitalization that channels are money into companies that are the most popular, most beloved and therefore the most vulnerable?” he asks.

Rob Arnott: The crash of the tech bubble

The fallibility of the method was exposed when the tech bubble burst, which in turn set Arnott thinking of a new method – weightage by fundamentals.

A very simple back test of Fortune 500 companies, weighted in a portfolio by proportion of their sales, revealed additional returns of 2.5% every year for the last 30 years.

“Most fund managers would sell their grandmother to get incremental returns like that,” says Arnott on the show.

That led Arnott to devise fundamental indexing, a method that relied on fundamental parameters such as sales and cash flow (which really represented the broad economy) and had the advantages of low-cost, low turnover, concentration in significant companies, and has large capacity as well.

How the method works

Fundamental Index works using the concept of “fundamental size,” which assigns portfolio percentages to companies on the basis of their size in the real economy as determined by their sales, profits, book value or dividends.

Arnott explained the difference with reference to Apple Inc. (NASDAQ:AAPL), a company that has the highest weightage by capitalization in the S&P 500, even though it is not the largest business in America.

In effect, the market is paying an advance premium today on the expectation that Apple will, on a future date, occupy that exalted position, observes Arnott. If that expectation is belied, the premium will vanish and the price will underperform, he says.

The largest business in America is undoubtedly Exxon Mobil Corporation (NYSE:XOM), and is therefore Arnott’s largest portfolio position based on the concept of fundamental indexing by size.

On the flipside, Arnott cites the example of Bank of America Corp (NYSE:BAC), which ranks among the largest American businesses on almost any conceivable metric, but is weighted far lower in the index on the market’s expectations that the bank would probably shrink in the future because of its many current problems.

In effect, Arnott’s portfolio would have a lower percentage of Apple and a higher proportion of Bank of America compared to the market index. The portfolio is re-calibrated on a quarterly basis to realign with changes in market fundamentals – portfolio “tilts,” according to Arnott.

“Fundamental Index serves as an anchor to contract trade against the market’s constantly changing expectations,” says Arnott, adding that it turns volatility into incremental return.

Fundamental Indexing is old hat: James Montier

Consuelo asked Arnott to respond to criticism from James Montier that Fundamental Index was just an amalgam of investment strategies that emphasized value and small caps, and therefore simply old wine in a new bottle.

Arnott acknowledged that Montier was brilliant, but not necessarily right.

Explaining that the emphasis on value and small caps arose from market mispricing that was captured by his method of Fundamental Index, Arnott disclosed that currently, he was invested more in large caps because the market was paying a premium on small caps. “Our tilts change,” he said. “We’re dynamic. We now have a large cap tilt. Whatever the market is paying the most for, we’re betting against.”

The clincher: “Because the market is always paying a premium for growth and assigning a discount for value, we will always have a value tilt.”

It doesn’t always work

“When growth is on a roll, when the market’s paying more and more for the high multiple growth stocks, we have a headwind,” says Arnott candidly. “But when it’s doing that we’re going deeper and deeper into value, and so when value snaps back, we earn it back and then some.”

“And that’s exciting.”

That One investment idea

“Emerging markets have fallen deeply out of favour lately – there is no such thing as a bargain that isn’t accompanied by fear – fear creates bargains – that’s why they are cheap!”

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