Steve Forbes Interview: Fundamental Index Pioneer Rob Arnott ~ MAKE MONEY BLOG$

Fundamental Indexing

Steve Forbes: Rob, good to have you with us, and can’t wait to ask you about indexing. Indexing has been a rage,

but you and a growing number of others are seeing there’s indexing and there’s indexing. Can you define for us what you call fundamental indexing and how it’s different from traditional indexing?

Rob Arnott: Sure. Well, indexing for decades has meant cap weighting. You weight companies in accordance with the total market capitalization of the company, the total value of the company in the stock market. And it got a helping hand early on, in the sense that the efficient market hypothesis said, “Stock picking is a waste of time.” Capital asset pricing model proved that if the market is efficient – and an array of other simplifying assumptions hold true – that you can’t beat the cap-weighted market on a risk-adjusted basis.

However, those assumptions are all not true. And so what we find is that with fundamental indexing, you’re weighting companies according to how big their business is, not according to how big the market thinks they’ll be in the future and pre-pays for today.

Forbes: So in essence you’re saying even indexing plays on emotions? It bets on the ones that are moving up and gets out of the ones that may be bargains?

Arnott: Think of it back in the way that Graham and Dodd viewed the world. Ben Graham didn’t think the market was a passive index at all. Ben Graham thought Mr. Market – he personified it and called it Mr. Market – was this nervous Nellie who was bidding up one thing and bashing down another, and that if you wait patiently and contra trade against Mr. Market you can earn a superior return.

Back in the days of Graham and Dodd, the market wasn’t perceived as passive. It was perceived as active. And relative to the economic footprint of a company’s business, it is active. It bids up what’s expected to grow fast. It pummels what’s expected to shrink. And fundamental index simply contra trades against that and says, “Okay. You like this company a lot? You hate this company a lot? It’s already in the price? Great. Let’s re-weight it to its company’s size and earn money on the rebalancing.”

Measuring A Company’s Business

Forbes: Now, measuring what you call the fundamentals. What does that involve?

Arnott: There are a lot of measures.

Forbes: It doesn’t involve profits, does it?

Arnott: It can. There are a lot of ways to measure the size of a company’s business. It can be based on sales, profits, book value, dividends. In fact, in the United States the biggest companies on each of those four measures – four different companies in four different industries. Wal-Mart is biggest on sales; Exxon Mobil is biggest on profits; GE is biggest on dividends; Bank of America, after all the write-offs, is biggest on book value.

You could argue endlessly about which is right, or you could simply average them and take the assumption that just as our footprint in the sand at the beach has multiple measures, length, width, and depth of the footprint, the footprint that a company has in the economy has multiple measures. Let’s take an average and use that as our anchor, as our rebalancing midpoint.

Forbes: But you’re now bringing in human judgment, are you not, in determining which of these measures you should use? That’s what John Bogle says.

Arnott: On one level, that’s absolutely correct. But what we did is select four measures that we thought were very different. We didn’t cherry pick the best performing. The other thing that’s interesting here is it doesn’t matter which measures you use. They all have about the same return. They all have about the same risk.

Forbes: So sales, cash flow, book value, dividends, profits?

Arnott: Any of those indexes.

Forbes: Profits would be the fifth one, wouldn’t it?

Arnott: Cash flow would be our measure of profits.

Forbes: Okay..

Arnott: And so any of those measures is a reasonable, objective measure of one element of a company’s size from the perspective of shareholders. And if you use that as an anchor to contra trade against the market when the market’s making extreme bets (you’re contra trading against that) on average and over time that works. Now, what’s interesting is they all work about the same. Using a blend, exposing the outliers, makes it a more comfortable ride.

Forbes: So you do 25% of each, or how?

Arnott: That’s exactly right. It’s really simple. The new Russell indexes use three measures. But they’re similar and they’re similarly complementary, and we just equal weight those three. The big outlier is cap weighting. It’s the only big outlier.

These are all clustered within half a percent of the composite. Cap weighting is 2% to 2.5% below, per annum, compounded for 50 years. Now, if you under perform by 2% a year for 50 years, it adds up hugely over time. The special attribute of cap weighting that the others miss is that it links the weight to the price. The higher the price, the more you have in it. What, exactly, is the logic behind indexing that way? Finance 3 says it’s right. Common sense says it’s not.

Higher Fees And Higher Risk?

Forbes: Now, what does this do to fees?

Arnott: Turnover is a little higher. It’s 10% to 15% a year, where with cap weighting is about 5%. So double or a little more.

Forbes: It’s not a budget buster.

Arnott: It’s not a big turnover.

Forbes: Does it increase risk?

Arnott: Sometimes it does. When the market punishes high-volatility companies with low valuation multiples, as it did at the bottom of the financial crisis, then yes, your risk goes up because you’re rebalancing into those companies. Most of the time, the companies with the high risk are high multiple companies, so most of the time it reduces risk. Sometimes not.

Forbes: And what does it do to small-cap stocks?

Arnott: That’s a really interesting question because the conventional view – Jack Bogle, Burt Malkiel criticized this for its small-cap bias. It has a small-cap bias. When small-cap stocks are trading at a discount, it re-weights them up. When they’re trading at a premium, it re-weights them down. So once in a while it has a large-cap bias relative to the cap weighted indexes. Big surprise to the casual critics.

Forbes: Now, you’ve done this for five years. You’ve said going back decades, you can see this thing with this kind of approach works if you stick to it. Is there a risk here? Not that they’re equal, but I remember hearing several years ago, “Housing has certain characteristics,” and then the characteristics changed, even though the past said they shouldn’t have changed.

Arnott: Right. Well, of course, nothing in life is assured and nothing in investing is assured by a long shot. But if you have a mechanism for contra trading against the market’s most extreme bets, we all know that rebalancing for asset allocation makes sense.

Why not do it within the stock market? Why stop at the borders of the stock market? Why not rebalance within the stock market? And if you’re going to do that, what metric are you going to use? Equal weighting? That’s weird. Why not weight on the size of a company’s business? So it makes intuitive sense.

Forbes: So it’s self-correcting?

Arnott: It can be. When you have the market paying a small premium for growth, relative to value, we’re going to contra trade against that and we’ll have a little bit of a value tilt. When the market’s paying a huge premium for growth over value, we’ll have an enormous value tilt. And so it is self-adjusting. The more the market pays up for growth, the more we bet against it. Iintuitively that makes sense, too.

Forbes: Now, in terms of the stock market itself, your approach – does this mean, in effect, the stock market is just going to reflect the economy?

Arnott: No. The stock market is forecasting winners and losers and the stock market does a wonderful job of that. Some of the early critics said, “These fundamental index people think they know what fair value is better than the market.” No. Absolutely not.

The market empirically – you can test it, you can prove it – the market does a better job of picking what’s going to win and what’s going to lose better than a fundamental index will. But what’s interesting is those forecasts of the market, they’re in the price. They don’t help you. They’re useless. And contra trading against the shifting views of the market in effect transforms the market’s volatility into incremental return.

Does Fundamental Indexing Work Abroad?

Forbes: Now, looking overseas. We’ll get, in a moment, to your third pillar in terms of investing in these crazy times. But have you done this kind of work and research for other countries? Does it work there, even in markets that aren’t very large by U.S. or European standards?

Arnott: Yes. We have distribution partners in Europe, Japan, Australia, even smaller markets like South Africa. And there’s about $55 billion now managed using fundamental index. About $35 billion of that’s non-U.S. So the idea has gained traction all over the world. What’s interesting is it adds value all over the world. We found typically 2% to 4% value added for the indexes since 2005 all over the world. The less efficient markets, small companies, emerging markets, the value add gets bigger.

And what I think is interesting about that is – think about the last five years. Has this been a period of time where our value bias (and we do have a value bias relative to the market) has helped? No. Except in emerging markets, value has underperformed the last five years, while we’ve outperformed. So I think the fundamental index has survived a very important proof statement by adding value when critics would have predicted, and did predict, it would fail.

Fundamental Bond Indexing Is More Intuitive

Forbes: In terms of bonds, you say this approach has even greater validity?

Arnott: Greater validity. Greater intuitive appeal, too. Think about bond investing. If you’re a bond investor, you’re a lender. If you index, you’re lending in direct proportion to the size of a borrower’s debt. Okay. And if the borrower wants to borrow more and you’re indexed, you have to lend them more.

What exactly is the logic in that? Doesn’t it make more sense to lend in approximate proportion to a borrower’s debt service capacity, to the amount of debt that they could comfortably carry? And then if they want to borrow less than that, great. You’re happy to be the dominant lender to them. If they want to borrow more than they have as capacity, you say, “Fine. Borrow from somebody else.”

With fundamental indexing applied to bonds, you’re weighting the bonds, if it’s corporate debt, in proportion to the size of the company’s business not in proportion to the size of their appetite for debt. If it’s a country, it’s in proportion to the size of the country’s economy, not in proportion to the size of their debt.

Forbes: How do you distinguish between, say, Greece, which over the line, pick a number, 140%, 170%, depending on the books that day; and Japan, which is way over the line, too – but everyone says Japan has a savings rate to sustain this insanity? Greece obviously doesn’t. How do you make adjustments?

Arnott: Fundamental index for bonds would sharply underweight both. Japan primarily loans to a domestic market and they won’t hit their wall until domestic savers are saving less than the government wants to borrow. We’re not there yet. At some point, they will hit their wall. And as Greece demonstrated, and as history has demonstrated countless times before, when you hit your wall you hit it hard and fast. Greece went from 6% to 22% on two-year notes in eight days.(continued)
Source: forbes.com
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