Proponents of passive investing like Roy Komack, president of Family Financial Architects, Inc., claim it produces better returns at less cost to clients, than actively managed investments. In fact, approximately 60 percent to 70 percent of the $100 million the Natick, Mass. firm manages for individual investors is in passive strategies. However, in August 2005, Family Financial made a change to its passive focus. Client assets are now being shifted from a traditional index fund into new funds employing a new methodology called fundamental indexing, which de-emphasizes market cap weighting in favor of other metrics.
Thus far, close to $15 million of Family Financial's assets under management has been shifted from the iShares Russell 1000 Index Fund into either the PowerShares FTSE RAFI US 1000 Portfolio or the PIMCO Fundamental IndexPLUS TR Fund. The firm's decision to invest client assets in fundamental indexing, Komack says, was based on the belief that it was a more sensible approach to passive investing than traditional capitalization-weighted indices.
Passive investment strategies provide numerous compelling advantages for clients including broad diversification, low turnover, full market participation, greater after-tax returns and lower management fees. "Academic research makes overwhelmingly clear the benefits of having the majority of investments in passive strategies," says Steve Condon of Truepoint Capital in Cincinnati, Ohio.
However, many observers point out that traditional passive investing strategies are also inherently flawed. Traditionally, portfolios utilizing passive investing strategies weight securities based on market capitalization. Markets, of course, tend to have inefficiencies, so stocks priced above true value will have erroneously higher capitalization and higher index weighting. "Capitalization- weighted indices systematically overweight overpriced securities and underweight under priced securities," says Robert Arnott, chairman of Research Affiliates LLC in Pasadena, Calif. "Why should we want to own more of a stock merely because it's overvalued?" Everyone knows that buying high and selling low is bad investment strategy, but that is exactly what happens in market-cap index funds because they reflect current market trends, explains Jerry Moskowitz, a managing director at FTSE America in New York.
Assuming that investors always act rationally also makes cap-weighted portfolios vulnerable to market bubbles and corrections. The point is, says Moskowitz, that markets do not always reflect real economic activity. During the technology bubble in the 1990s, for example, cap-weighted indices assigned too much weight to overvalued Internet stocks. FTSE rebalances its index funds annually, explains Moskowitz, so in 2000, technology industry stocks went from comprising 20 percent of index portfolios to 30 percent.
At Research Affiliates, Arnott developed the concept of fundamental indexing to get around the disadvantages of capitalization-weighted passive strategies. Fundamental indexing uses fundamental measures of firm size, not market capitalization, in index construction. In fact, Research Affiliates employs four specific metrics in fundamental index construction: book equity value, free cash flow, sales and gross dividends.
By weighting securities on fundamental metrics related to company size, the linkage between portfolio weight and any over- or under-valuation is eliminated. Fundamental indexing can protect a passive investor against market bubbles and fads, says Arnott, because a stock's weight in the index is immune to errors in stock pricing.
Proponents argue that fundamental indexing provides all the benefits of traditional cap-weighted passive investing, including diversification, broad market participation, liquidity and low turnover, while generating incrementally higher returns with lower volatility. By using other [than capitalization-weighted] schemes, a passively invested portfolio can eliminate drag and increase overall returns. It also avoids stock price run ups and subsequent corrections which historically plagued cap-weighted indexes. Advisors can gain exposure to fundamental indexing for clients through a number of venues including exchange traded funds (ETFs). FTSE offers 11 Research Affiliates LLC Fundamental Index (RAFI) funds which invest in the U.S. market including the FTSE US RAFI 1000. FTSE is planning on rolling out 11 new Fundamental funds in 2007, says Moskowitz. The new funds will invest internationally and include regional, country and global funds. The FTSE funds do not require minimum investments, and are traded on both the NYSE and Nasdaq.
According to Arnott, from 1962 through 2004, a market index of the 1,000 largest U.S. companies based on revenue, weighted according to revenue and rebalanced annually saw an annualized return of 12.9 percent. The S&P 500 annualized return for the same period was 10.5 percent. Thus, a dollar invested for the full 42 years in the S&P 500 index would have grown to $73.98, while that same dollar invested in a revenue-based index would have grown to $182.23. Revenue-based indices outperformed in both bull and bear markets, when the economy expanded and contracted, and when interest rates rose and fell, Arnott says.
"It should be no surprise that using factors other than market cap produces superior returns. In fact, one may wonder why it took so long for fundamental indexing to become popular," says Christopher J. Cordaro, chief investment officer for RegentAtlantic Capital LLC. Portfolios which utilize fundamental indexing, he says, have a bias towards small cap and value stocks, and that provides superior performance.
Cordaro's firm has been using a fundamental indexing approach to managing large cap stocks since 2002. It does not use a mutual fund or ETF, but a portfolio of individual stocks with selection criteria based solely on fundamental factors including book, earnings and revenue. "We chose not to use a mutual fund to implement this strategy so that we could run our portfolios in a super tax-efficient manner" explains Cordaro.
In addition to returns, proponents argue there are other compelling reasons to invest client assets in fundamental indices. "Even within the index portfolio, there should be some diversification," says Moskowitz. "Fundamental indexation is just another way to capture diversification so that the entire passive investment portfolio is not solely cap weighted."
Detractors of fundamental indexing, however, argue that the same results can be had at lower costs using traditional funds. Fundamental indexing results in portfolio bias towards value stocks, and there are other, cheaper ways to replicate that result--including investing in traditional value/small-cap index funds such as the Russell Value 1000 Index fund, says Richard Freeman, a principle in Round Table Services LLC in Westport, Conn. Fundamental-weighted index funds have a higher expense structure, he says, than traditional index funds. Funds employing fundamental indexing also are less tax efficient than value funds, he adds, because the methodology requires more adjustments.
Fundamentally indexed funds clearly resemble small-cap value funds like the Russell 1000, says Moskowitz, but there are clear differences as well. The FTSE RAFI 1000 fund gives investors exposure to large-cap growth stocks such as Microsoft, while the Russell fund does not. Therefore, should there be a growth spurt of large-cap growth companies, RAFI fund investors will participate.
Moskowitz also disputes claims that the Russell fund is cheaper. "The costs are different, but the difference is moderate," he says. Furthermore, he adds, the RAFI fund slightly outperforms the Russell fund in both down and up markets. According to Research Affiliates data, on average, the RAFI 1000 value has returned an average of 17.8 percent average annually, gross of fees, since 1979 compared to 14.5 percent from the Russell 1000 Value. In the last 10 years, the RAFI 1000 has produced an additional 4.9 percent return over the Russell 1000 Value. Similarly the RAFI 2000's average annual return was 16.7 percent compared to the Russell 2000's 13.2 percent. In the last 10 years, the RAFI 2000 produced a 5.7 percent excess return over the Russell 2000.
Moskowitz does admit, however, that RAFI funds are not as tax efficient as the Russell fund. The RAFI 1000 averages a 10 percent turnover, while the Russell fund's average turnover is 7 percent. On the other hand, he says, the additional tax advantages are wiped out due to the superior returns on the RAFI 1000 in both up and down markets.
Komack agrees that RAFI funds have higher expenses, but he does not view the higher expense ratios of fundamentally indexed funds as a deterrent to investing in them. Even with the current fees, performance should be approximately 200 basis points above the Russell 1000, he says, or 2 percent-a-year better. "If you get an additional 200 basis points annually for an additional 30 to 40 basis points in fees, then you're still ahead," he says.
Furthermore, newer funds typically have higher expense ratios, adds Komack, and as more money pours into these funds, it should lead to lower fees. Fees may also eventually go down as more funds are developed, and more money goes into them. There are dozens of S & P 500 Index funds, he notes, so traditional index funds have to compete on the basis of price. There still are not that many fundamentally indexed funds, so the competition is not as great.
But additional costs have dissuaded Truepoint Capital from investing in fundamentally indexed funds, says Condon. Truepoint, which manages $550 million for clients, puts 80 percent of its equity holdings into passive investments. Truepoint does not invest any client assets in fundamental index funds, Condon says, but does invest in another fund with a value and small-cap bias with fees that are approximately one-half those of the fundamental funds. Still, Condon has not ruled out fundamental funds forever. "If costs were to go down on fundamental index funds, we would reconsider them," says Condon. "We'll continue to evaluate them, but at this time, we don't think they offer the ultimate strategy."
Other advisors argue that costs are relative, depending on the client. Cordaro believes that fundamental indexing strategies work best for clients with at least $200,000 to invest in large-cap stocks. For clients with less than $200,000 to invest in such stocks, it probably makes sense to wait until a less expensive alternative comes along, he says.
The problem for smaller clients, of course, is the high fees associated with fundamental indexing strategies, but that may change, Cordaro points out. "As fees come down we'll probably shift more clients into it," he says.
Debate over new investment strategies is nothing new. "Ten years ago there was a raging debate about active versus passive investing," says Cordaro, "Now most do both. In the same way, indexing isn't a black or white issue--it's what works best for the client. You can use both in a client's portfolio." Fundamental indexing strategies have already made significant inroads among institutional investors--particularly in public pension funds--and some believe that fundamental indexing will be adopted whole-heartedly by individual investors and their advisors as well. "I believe we are in the very early stages of a significant shift in how investors approach passive investing," says Arnott.
Fundamental indexing strategies will continue to outperform both the S & P 500 and traditional value/small-cap funds, predicts Cordaro, leading to increasing investor activity. And as new international funds employ this strategy, Komack believes their appeal will expand even further. "The data shows that they should have even stronger returns," he says.
Elayne Robertson Demby, JD, has covered executive compensation, employee benefits, and financial issues for more than 10 years.