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Pro Money Talk » 2007 » October

Archive for October, 2007

Interview with Rob Arnott - Chairman and Founder of Research Affiliates

Wednesday, October 10th, 2007
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In this episode we interview Rob Arnott chairman and founder of Research Affiliates, about his pioneering innovation called “fundamental indexing”. This is one of those evolutionary shifts in thinking that is generating great debate in the advisor community and could radically change the way individuals invest.

In short, Arnott identified a major problem with typical index investing and found a potential solution. The problem is that indexes are “cap weighted” so that companies that are overpriced make up more of the typical index than companies that are underpriced. Obviously since prices tend to revert towards their mean, or true value, this cap weighting hurts overall performance.

The problems with cap weighting were illustrated in 2000-2002. In 2000 the average stock was up, as it was in 2001 and 2002. But in 2000 and 2001 the indexes took a big hit. The reason for this was because technology stocks had become seriously overvalued, the prices were way too high. This overvaluation meant that their cap weight was very high, giving them a disproportionate weight in the index. Therefore when those stocks crashed, and because they had become such a large piece of the indexes, they brought the entire indexes down.

Had the indexes not been cap weighted, but weighted on traditional methods of determining size, the indexes would not have crashed. Arnott went beyond that to look back over 45 years to determine the difference in returns between a fundamental index and cap weighted index. He found that over that period of time, the fundamental index outperformed a cap weighted index by 2.2% per year, compounded. He also found that traditional risk measurements showed a fundamental index to be slightly less risky than the cap weighted index

Why do we cap weight stocks?
1. The markets are cap weighted, therefore cap weighted indexes represent the performance of the markets as a whole
2. It’s been done this way for a long time
3. It does better than the average actively managed fund

However, that does not mean it’s the most efficient way of weighting stocks. Arnott argues that sales, revenues, earnings, cash flow, assets, book value, dividends, number of employees, and other traditional methods of determining size of companies is more efficient. So fundamental indexing gives bigger weights to bigger companies, irrespective of stock value.

In short, a fundamental index weighs the company, not the stock price. It erases the problem of over weighting overvalued stocks and under weighting undervalued stocks.

When applied worldwide, it was found that fundamental indexing could improve international investing by 3%. Not only do stocks have bubbles but countries have bubbles too, therefore fundamental indexing works well not just on US stocks, but on a worldwide basis as well.

Find out more about Rob and Research Affiliates here Research Affiliates®

Articles on fundamental investing:

A better way to index? - October 30, 2006
Fundamental index funds merit a look - InvestmentNews
Index Wars (PowerShares FTSE RAFI U.S. 1000 Portfolio, SPDR Trust) |
PIMCO Bonds - Arnott Fundamental Indexing Interview

Wikipedia definition of fundamental indexing:

Fundamentally based indexes - Wikipedia, the free encyclopedia