For many investors, index investing is where they want to be. It is inexpensive, allows broad participation in the market, and can be finely diced into sector and other sub-index pieces. Index investing has traditionally been linked to capital-weighted indexes, whereby a company’s market cap determines how much of a company actually got into an index. And that’s the fatal flaw in conventional index-linked investing, according to Robert Arnott, chairman of Pasadena-based Research Affiliates and editor of the Financial Analysts Journal.
Arnott, the former chairman of First Quadrant, and global equity strategist at Salomon Brothers, has developed the radically different concept of fundamental indexing, which uses a company’s fundamentals: sales, profits, book value, and dividends to determine its weighting in an index. Arnott says the problem is that cap-weighted index investing “overweights a portfolio with overvalued stocks and underweights it with undervalued stocks.”
Things are moving fast for Research Affiliates: last November, FTSE started publishing 37 Research Affiliates Fundamental Indexes (FTSE/RAFI Indexes). In the U.S., PIMCO has developed the first fundamental index-based mutual funds–Fundamental IndexPLUS and Fundamental IndexPLUS TR. In addition, PowerShares launched broad market FTSE/RAFI ETFs last fall, and now advisors can choose from nine new FTSE/RAFI sector ETFs. Other countries are adding foreign RAFI-linked ETFs as well. Arnott estimates that there is about $4 billion in assets invested in RAFI strategies worldwide, up from $100 million in December 2004. While that may be a drop in the bucket compared to the estimated $2 trillion worldwide linked to cap-weighted indexes, fundamental indexing has clearly been noticed.
How did fundamental indexing start?
S&P introduced the first cap-weighted index in 1957. It is astonishing that in 50 years no one had tested the structuring and weighting of an index based on other measures of company size.
People have looked at equal-weighting and they have puzzled over why it’s better and they’ve come up with answers about a small-cap tilt, a value tilt, and so forth but the real reason equal-weighting wins is because it’s not drawn into a weighting structure that guarantees that you’re overweight the overvalued and underweight the undervalued; that directly links the weight in the portfolio to the error in the price. If your weight is proportional to price and that price itself ever departs from the true fair value–and of course we know it does–then price will be over or under true fair value, and the weight of every company overvalued is going to be too high, so you wind up chasing every bubble that comes along, you wind up doubling your weight in an investment just because it’s doubled in price–well that makes no sense. We decided to test other ways of indexing and as we did those tests, [weighting the fundamentals] the relative performance was shocking: 2% to 3% value added, per year, compounded over long periods of time.
This stimulated some research into the theoretical backdrop–why does it work so well? It works so well because the link between portfolio over- and undervaluation and the weight in the portfolio has been severed; you’re not overweighting the overvalued and underweighting the undervalued. You don’t know which companies are over- and undervalued but you do know weighting by market cap assuredly overweights the overvalued and that weighting by simple measures of a company’s size isn’t going to expose you to that, because price, P/E ratios, valuation multiples, market cap are not part of the decision as to what weight to put into a stock.
Explain equal-weighting versus fundamental weighting.
Equal weighting is you take the S&P 500 and put 1/5th of a percentage in each stock. That adds a lot of value. It also is relatively higher volatility, higher turnover and it’s expensive to run, but it does work. Fundamental indexing works better because with equal-weighting the S&P you’re still left with a universe that is biased–you’re still left with companies that are popular, trendy, comfortable, and therefore probably aren’t priced attractively.
With fundamental weighting what are you looking for?