The idea that market indexes can be fundamentally
weighted by important financial metrics hasn't just shaken the ETF industry -
it's shaken the entire world of modern finance.
It's sparked a heated debate between supporters of
traditional market cap weighted indexes and a newer generation of indexers that
think they have a better solution.
At the epicenter of this controversy is Robert
Arnott, Chairman of Research Affiliates. His firm has been pioneering new ways
of constructing market indexes and he
takes time to visit with
us.
Q: Are fundamentally weighted portfolios
really "indexes?"
RA: It depends entirely on how
one defines “indexes.” From a CAPM perspective, anything that’s not cap-weighted
is neither passive, nor is it an index (although the indexing community leans
towards the decidedly non-CAPM-compliant perspective that float-weighting is
somehow preferable). By this definition, "Fundamental Index" is decidedly
neither passive, nor an index. If, alternatively, we define an index as
something which is formulaic, objective, transparent, historically replicable
and low-turnover, Fundamental Index qualifies on all counts. Ironically, many
of the cap-weighted don’t qualify for this simple pragmatic definition of an
“index.”
I don’t
really care whether people think that Fundamental Index is an index or an active
portfolio. Either way, it’s an utterly simple concept with powerful practical
and theoretical implications. Indeed, the empirical evidence surrounding
Fundamental Index calls some well-respected theories like efficient markets and
CAPM into some question. Rather than arguing about whether these are indexes or
not, shouldn’t we (1) enjoy the risk-adjusted alphas that come from the concept,
and (2) recognize that the elegant theories of modern finance may need some
tweaking to better fit the real world?
Q:
Regarding the turnover of holdings and rebalancing, how do RAFI's fundamentally
weighted indexes compare to market cap-weighted ones?
RA:
The Fundamental Index concept can be anything from extremely low turnover to
extremely high turnover. If one wanted to rebalance back to the fundamental
weights for individual company’s every single day, the turnover could easily
exceed 100 percent per annum. If one does it quarterly, the turnover tends to be
30-50 percent. If one does this annually, the turnover tends to 15-25
percent. And if one does it annually based on smoothed long-term measures of the
fundamental scale of the company, the turnover drops to the 10-15 percent
range. This compares quite respectively with the average turnover of the
capitalization weighted indexes, which range from roughly 6 percent (the 45-year
avg. turnover for the S&P 500) to 30-40 percent for niche indexes likes Russell
2000 value.
Q:Fundamental
Indexes, can use many financial measures (book value, earnings, dividends, etc.)
- is there any one single metric that's more important than the next?
RA: Empirically, some
fundamental measures are more powerful than others, but the range is
surprisingly narrow. The gap between the best and worst single-metric approach,
a sales-weighted Fundamental Index and a dividend-weighted Fundamental Index, is
barely 90 basis points averaged annually over the past 45 years. Sales is the wellspring
from which profits, book value and dividends must flow; so, it makes sense that
sales works best and dividends works worst. But there is also a link with risk.
A sales-weighted Fundamental Index is the most volatile and works best in bull
markets, while a dividend-weighted Fundamental Index is the lowest-volatility
and works best in bear markets (while failing miserably in most bull markets).
This is
why we favor using a blend of measures. It results in a lower tracking error
than any single-metric Fundamental Index, lower volatility than the average
Fundamental Index, higher returns than the average Fundamental Index and the
highest information ratio of any Fundamental Index. It also has, by good margin,
the lowest turnover.
The
most important single metric is not even part of the Fundamental Index: it’s the
cap-weighted index. While no Fundamental Index is even 0.5 percent away from
the average return of RAFI, cap-weighting is 220 basis points off the pace.
Accordingly, avoiding cap-weighting (or indeed any price-sensitive weighting
scheme) is vastly more important than the selection of which Fundamental
Index to rely upon.
Q:
Many of RAFI's stock indexes have a bias toward value and smaller cap stocks.
What happens when these areas are out of favor?
RA: RAFI weights companies by their economic footprint. Accordingly, it
is utterlyneutral relative to the composition and weightings of
business enterprises in the economy. Cap-weighting, in contrast, have a stark
growth tilt. Companies at twice the market multiple get double their economic
weight in the cap-weighted portfolio, while companies at half the market
multiple get half their economic weight.
In 1997, Cisco was 0.5 percent of the market,
at thirty times earnings. By 2000, it was 4% of the market, at one hundred
thirty times earnings. Did it comprise 8 times as much of the market as the peak
of the bubble because it was 8 times as attractive at a PE of 160 than it was at
30 times earnings? Of course not. The weighting went up 8 fold because the stock
went up 8 fold relative to the average stock, and because it was now at 160
times earnings.
Our Fundamental
Index doesn’t get drawn into this sort of bubble, though it also doesn’t weight
growth companies more heavily than value companies even when they deserve the
higher multiples.
Q:
What about other
securities besides stocks? Can fundamental weightings be applied?
RA:
The short answer is “yes.” I can’t go into detail on this question, because
it’s an area of active research at Research Affiliates. That work is hopefully
protected by the same pending patents as RAFI. We have a draft paper with Harry
Markowitz and Jun Liu, which explores the mathematics behind Fundamental Index.
So long as price is randomly distributed around value, not the other way around
(which Efficient Markets Hypothesis assumes), the value that is forfeited by
cap-weighting is proportional to the square of the pricing error.
Accordingly, if you double the pricing error, you quadrupled the value-added in
a valuation-indifferent index. This has implications for the bond world, where
pricing errors are small, so a bond-based Fundamental Index should add a trivial
increment to returns; reciprocally, in emerging markets, the pricing errors are
presumably huge, and the impact of RAFI on performance is quite remarkable.
