Robert Arnott: Market capitalization weighted indices are popularity driven

Robert Arnott, chairman and CEO of Research Affiliates, sat with Barry Ritholtz, founder and chief investment officer of Ritholtz Wealth Management and Bloomberg radio “Masters in Business” host on July 19. In the interview, Arnott noted that he found market cap weighted indices emphasized overpriced stocks driven by bets made by most investors. For example, in 1999 and 2000 valuations of stocks such as Cisco Systems, Inc. (NASDAQ:CSCO) were inflated as investors were betting on continued outperformance in technology, the popular sector. The market corrected in 2000 and Cisco is trading at $25.97/share as of July 25, 2014 after trading at about $80/share in early 2000. Arnott believes that market capitalization weighted indices magnify losses when markets mistakenly bet that a given stock may outperform. The price of such stock gets inflated which in turn increases the weight in the index. When the stock falls, the market capitalization weighted index loses more as the overpriced stock has a larger share in such index.

Fundamental Indices: Focuses on economic significance of companies

A viable alternative to a market cap weighted index is a fundamental weighted index. Arnott determined index weights by measuring variables that will illustrate how a given stock influences the economy. He used a model that included sales, profits, dividends and price/book (P/B) ratios. Arnott then averaged the four measures for stocks and the average became the weight of the stock in his index. Using variables that take away the impact of current stock prices allows investors to consider companies that may be underpriced and improves diversification. Investors are not as exposed to market fluctuations as weights on overvalued companies are not as high relative to market cap weighted indices. Arnott’s fundamental weighted index outperformed the S&P 500 market cap weighted index by an average of 2% annually over 40 years ending in 2005. The largest exposures in Arnott’s index include Exxon Mobil Corporation (NYSE:XOM), Wal-Mart Stores, Inc. (NYSE:WMT) and Bank of America Corp (NYSE:BAC). Research Affiliates currently has about $170 billion in assets under management worldwide. The firm provides input to institutions including Charles Schwab Corp (NYSE:SCHW), PIMCO and ProShares.

Arnott Fundamental Indices

Research Affiliate Fundamental Index (RAFI) outperforms both equally weighted and cap weighted strategies.

The full interview is embedded below