The Fundamental Index E-Book

Robert D. Arnott

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 447

Veröffentlichungsjahr: 2011

Beschreibung

2008 American Publishers Awards for Professional and Scholarly Excellence (The PROSE Awards) Finalist/Honorable mention, Business, Finance & Management. The Fundamental Index examines a new approach to indexing that can overcome the structural return drag created by traditional capitalization-based indexing strategies, and in so doing, enhance the performance of your portfolio. Throughout this book, Robert Arnott and his colleagues outline this breakthrough strategy and explain how it can be used to improve investment returns, typically at lower risk and lower cost than most conventional investments.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Foreword

Preface

CHAPTER 1 - Efficient Indexing for an Inefficient Market

Evidence of Market Efficiency

The Case for Indexing

Evidence of Market Inefficiency

Conclusion

CHAPTER 2 - Origins of the Fundamental Index Concept

Origins of the Research Affiliates Fundamental Index (RAFI)

A Series of Aha! Moments

Research Affiliates Fundamental Index

Fundamental Index Performance

Concluding Thoughts: A Better Way to Invest

CHAPTER 3 - Investors’ Greatest Errors

Negative Alpha

Practicing What We Preach

Conclusion

CHAPTER 4 - The Virtues of Index Funds

Appeal of Equity Investing

Equity Investing Choices

The One Guarantee in Investments—Cost Matters

Index Fund Advantages

Avoiding the Performance Game

Concluding Point

CHAPTER 5 - The Index Fund’s Achilles’ Heel

Market Efficiency: Two Interpretations

Constructing a Well-Functioning Index

The Achilles’ Heel of Cap Weighting

The Problems with Equal Weighting

Concluding Thoughts

CHAPTER 6 - A Fundamental(ly) Better Index

Building the Fundamental Index

Adjustments for Non-Dividend-Paying Companies

Why Multiple Measures of Company Size?

Advantages of a Composite Measure

An Index of the Broad Economy

Capacity and Liquidity

Reconstituting the Fundamental Index: Keeping Turnover Low

Concluding Comments

CHAPTER 7 - Fundamental Index Performance in U.S. Stocks

RAFI U.S. Large Company Performance

Digging Deeper across Market Cycles

Digging Deeper into Different Time Periods

An Equal Comparison: Fundamental Index versus Equal Weighting

Out-of-Sample Results: Small Companies

Using the Fundamental Index with Style: Growth and Value Applications

Narrowing the Focus

Extending the Analysis Back in Time

Conclusion

CHAPTER 8 - Beyond Borders: Fundamental Index Performance in Global Markets

Global Markets

Multicountry Portfolios

Emerging Markets

Consistency Counts

Concluding Lessons from the Global Markets

CHAPTER 9 - Has Theory Led the Profession Astray?

Will the Real Active Strategy Please Step Forward?

The Origins of Cap Weighting

Validation of Cap Weighting by Theory

40 Years Later: Empirical Results of the CAPM

Ockham’s Razor Applied

Concluding Comments: Theory and the Profession

CHAPTER 10 - The Basic Criticism: Our Style and Size Tilt

Merely a Value Tilt

Small-Cap Bias

Fama and French Factors

Some Big Surprises in Small Companies

A Proof Statement in 2007

Conclusion

CHAPTER 11 - Other Common Critiques: Hits and Misses

Mining the Data?

Costs

Is It an Index?

Do We Know Which Stocks Are Overvalued?

How Long Can It Last?

Conclusion

CHAPTER 12 - Why Trust the Fundamental Index Concept?

Stock Logic

The Present versus the Future: How Often Is Wall Street Right?

Why Does Wall Street Get It Wrong?

Dynamic Style and Size Exposures: When Do We Want Value and Small Cap?

Show Me the Numbers

Fundamental Index Strategy versus the Crystal Ball

Does the Fundamental Index Concept Work in Bonds?

Conclusion

CHAPTER 13 - Finding Opportunity in a World of Lower Returns

What Can We (Rationally) Expect from Our Investments?

Forecasting Bond Returns

Forecasting Stock Returns

Investing in a Low-Return Environment

The Outlook for Pricing Errors

Could Pricing Errors Actually Increase?

Conclusion

CHAPTER 14 - Using the Fundamental Index Strategy

Asset Allocation and the Fundamental Index Strategy

Should We Change Our Benchmark?

Diversifying the Passive Allocation

Different Markets, Different Investors, Different Needs

Conclusion

Appendix

Notes

References

Index

Copyright © 2008 by Research Affiliates, LLC, Robert D. Arnott, Jason C. Hsu, and John M. West. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The material contained in this book is for information purposes only and is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. The information contained herein shall not be construed as financial or investment advice on any subject matter. Neither the authors, their employer, Research Affiliates, LLC nor the publishers and their related entities warrant the accuracy of information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this book is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this material should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor the authors shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at [phone], outside the United States at [phone] or fax [phone].

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

The trade names Fundamental Index®, RAFI®, and the Research Affiliates® corporate name and logo are registered U.S. trademarks and are the exclusive intellectual property of Research Affiliates, LLC. Any use of these trade names and logos without the prior written permission of Research Affiliates, LLC is expressly prohibited. Research Affiliates, LLC reserves the right to take any and all necessary action to preserve all of its rights, title and interest in and to these terms and logos.

Fundamental Index®, the non-capitalization method for creating and weighting of an index of securities, is the patent-pending proprietary intellectual property of Research Affiliates, LLC (Patent Pending

Publ. Nos. US-2005-0171884-A1, US-2006-0015433-A1, US-2006-0149645-A1, US-2007-0055598-A1, WO 2005/076812, WO 2007/078399 A2, EPN 1733352, and HK1099110).

Library of Congress Cataloging-in-Publication Data:

Arnott, Robert D.

The Fundamental Index : a better way to invest / Robert D. Arnott, Jason C. Hsu, John M. West. p. cm. Includes bibliographical references and index.

ISBN 978-0-470-27784-3 (cloth)

1. Index mutual funds. 2. Stocks--Prices--Mathematical models. 3. Portfolio management. I. Hsu, Jason C., 1974- II. West, John M. (John Michael), 1973- III. Title. HG4530.A74 2008 332.6--dc22

2007052404

For George Keane. None of this research would have taken place without his persistent insistence that “there has to be a better way.” And there is.

Foreword

There is no free lunch.

—Milton Friedman

In The Fundamental Index, Rob Arnott and his colleagues essentially argue that a portfolio whose holdings are proportional to a suitable measure of the efficiency of a firm will outperform one whose holdings are proportional to the market value or capitalization of the firm. In other words, what I will refer to as an efficiency-weighted portfolio will outperform a capitalization-weighted portfolio.

The implications of efficiency-weighted index investing will be significant for investors and, thus, are worth the time of a short mathematical review of the logic. Over and above the dividends that corporations pay, and the long-run growth in their stock values, the holding and trading of securities is a zero-sum game. If some investors make more than others, then someone is consuming someone else’s lunch. To analyze this argument, let us focus on the zero-sum value-added game that the market participants play, ignoring dividends and long-run growth.

Suppose we have four companies, each with $1 in reported earnings. Suppose two of these have ample future growth prospects that would justify a price 20 times the current profits, or $20, and the other two have less impressive prospects and fully deserve $10—10 times the current earnings. But, no one can have a clear view of the future prospects of our companies, so the market merely guesses at these fair values. Suppose the market does a pretty good job, but misjudges those prospects by 20 percent in each of the four cases, with one growth stock priced 20 percent too high and one 20 percent too low, and likewise for the value stocks. So, we have two stocks with a true value of $20 each, priced at $24 and $16, and two stocks with a true value of $10, priced at $12 and $8.

Suppose prices revert to fair value in the next year. The “cap-weighted” portfolio produces zero return; since the prices are symmetric around value, the errors cancel. If we could construct a fair-value-weighted portfolio, few would disagree that it should be better than capitalization weighting. It is. Half of our portfolio rises 25 percent in value, and half loses 16.7 percent, for an average of 4.2 percent return. Why? Because the fair value portfolio puts equal amounts in over- and undervalued stocks, while capitalization weighting put 60 percent of our money in the overvalued and 40 percent in the undervalued companies.

Since we have no idea what the fair value is for each company, and so there’s no way for us to construct this fair-value-weighted portfolio, why should we care that fair value weighting beats capitalization weighting? What of the other construction methods? The portfolios weighted equally and by company profits (efficiency-weighted), which lead to the same weighting in this example, produce a return of 4.2 percent also, identically the same as the fair-value-weighted portfolio!

How can this be? It’s at odds with classical finance theory, which says that we can’t beat the cap-weighted portfolio. But classical finance theory is largely built on a foundation of efficient markets under doubtful CAPM assumptions, which implies that future prices are randomly distributed around current price. We are subtly changing this assumption. In fact, we are assuming the opposite: that current price is randomly distributed around fair value. As long as capitalization weighting has errors relative to fair value and prices revert toward fair value, capitalization weighting will suffer this drag relative to fair value weighting. And any portfolio that differs from fair value weighting in a fashion that is uncorrelated with the error in the price will match the return of the fair-value-weighted portfolio!

The reason I refer to this procedure as efficiency weighting is that, on average, the company that has greater profit per unit of market valuation is more efficient than the one with less profit per unit of market valuation. Perhaps there are extenuating circumstances in some instances. But this washes out on average. As a whole, the companies with greater profit per unit of market valuation are more efficient and are a more profitable investment.

The preceding example would seem not to be an equilibrium, since the cap-weighted investors gain nothing while the efficiency-weighted investors are getting richer. Asymptotically, the former disappear and the latter become the whole market. However, we have not said that the same players continue indefinitely. We may assume that some investors go out of the market and new ones come in.

In short, the answer to the question of how efficiency-weighted investors can continually take money from the cap-weighted investors is expressed in the saying attributed to P. T. Barnum:

There’s a sucker born every minute.

—HARRY MARKOWITZ

Preface

Victory has a hundred fathers, and no one acknowledges a failure.

—1942 G. Ciano Diary 9 Sept. (1946) II. 1961

It is a rare joy to have an opportunity to explore an idea that offers both powerful practical applications and potentially important theoretical implications. Such is the case for the Fundamental Index®2 concept—a simple idea which has the potential to “fundamentally” change the way we think about investing and markets. For 30 years, index funds, with next-to-nothing in trading costs and management fees, have proven to be formidable competitors to active managers who have had difficulty overcoming the corrosive effects of higher transaction costs and management fees.

Attractive as the index fund is as an investment concept, the capitalization-weighted implementation of the index fund concept is flawed. Because the size of our investment in any company is directly linked to stock prices, the capitalization-weighted portfolio overweights the overvalued stocks and underweights the undervalued stocks, leading to a performance drag on portfolio returns. The venerable index portfolio can be significantly upgraded by shifting our frame of reference from a market-centric to an economy-centric view of our investable universe, and the benefits to the investor are significant.

In the market-centric approach, we view our investment choices relative to those available in the stock market with companies weighted in accordance with their relative market capitalization. Finance theory supports this idea, subject to a few simplifying assumptions, notably that all prices are correct, that stock prices identically equal fair value, based on all available information. But these assumptions are not realistic. Most importantly for investors, if prices are wrong, we’re going to wind up putting most of our money in overvalued stocks because the scale of our investment is explicitly linked to the stock’s price, hence to the error in that price.

In the economy-centric approach, we view our investment choices relative to those available in the economy, with companies weighted in accordance with their relative economic scale. Because there are many measures of a company’s economic scale—sales, profits, number of employees, dividends paid, net assets, and so forth—we can use any of these measures, or a combination of them, to gauge company size. If we do this, we still make mistakes—owning some companies that we wish we hadn’t and underinvesting in the most stellar successes—but the size of our investment is no longer directly and irrevocably linked to the error in the price. As a result, pricing errors cancel and the performance drag is eliminated.

What causes this performance drag? The answer relates to the fact that structurally the market portfolio—the cap-weighted portfolio of all publicly traded stocks—will put most of our money in “growth companies,” stocks that trade at premium multiples because they are expected to exhibit stronger future growth prospects than the broad market. What’s wrong with that? In an efficient market, nothing at all. Their superior future growth will fully justify the premium prices that we pay. But are they superior stocks? Are they superior investments? In an efficient market, the answer to both questions is “no” because we’re prepaying for their superior future growth exactly enough to result in the same risk-adjusted return as the value stocks.

This is the Achilles’ heel of capitalization weighting: We invest much of our money in high-flying growth companies because they’re at premium multiples. And if the market falters in its efficiency, pricing some stocks too high and some too low, capitalization weighting assuredly suffers a performance drag relative to its opportunity set. The indexing community and the academic community do not worry about this because they take the notion of market efficiency seriously. In academia, market efficiency is accepted with near-religious fervor—even though fair value can never be measured and so the thesis of market efficiency can never be proved!

The theoretical implications are potentially profound. If some stocks are above fair value, they are also above their fair value market capitalization. Because they will crowd out some companies that better deserve the high market capitalization, and because they will eventually underperform (after all, isn’t that the ultimate definition of being overvalued?), this creates the much-studied “size effect.” The overvalued stocks will also be above their fair valuation multiples (price-earnings, price-sales, price-book, and price-dividend ratios); as they eventually underperform, this creates the much-studied “value effect.” Because most of the overvalued stocks will typically have reached that overvaluation by outperforming other stocks and will ultimately underperform, this creates the much studied long horizon mean-reversion effect.

Academia has developed many advances on the capital asset pricing model, including the arbitrage pricing theory, international CAPM, Fama-French-Carhart, and so forth. Some of these, notably Fama-French-Carhart, do a superb job of helping us to understand how one strategy may differ from another and why some strategies perform better than others. But the efforts to conform these models to an “efficient market” have been clumsy at best, with tortured explanations of “hidden risk factors” that attempt to explain performance differentials. If a strategy outperforms, they argue, it must have more risk, even if we can’t see or measure it.

None of these complications is needed if we merely acknowledge that price and value may differ. If we allow that prices may equal fair value plus or minus a constantly changing error, the value effect is expected, as is the size effect, as is long horizon mean reversion. Three of the most examined “anomalies” in modern finance very nearly become preordained if we accept that price may be wrong!

This brings us almost all the way back to the single-factor Capital Asset Pricing Model (CAPM) of Sharpe, Lintner, Mossin, and Treynor. CAPM plus noise explains every bit as much of what we observe in the real world as the multifactor models, with their hidden risk factors, that have almost replaced CAPM. Isn’t it more elegant to assume CAPM plus noise rather than to create convoluted explanations that can fit a “round” set of data into a “square” box of efficient markets?

The CAPM and the Efficient Market Hypothesis (EMH) are the reasons the Fundamental Index concept has stimulated such controversy in the academic community, with some of the top professors in finance, including Nobel laureates, squaring off on both sides of this debate.

The debate in the practitioner community is no less intense. Previous to the Fundamental Index idea, asset managers and advisors first made the determination of whether prices were reasonably efficient. Virtually none would subscribe to the notion that the market correctly values every stock at every moment of every day. Depending on where they came out on this market efficiency question, they would then choose whether to establish stock market exposure through active management or traditional index funds.

For those who believed, indeed knew, that price and value aren’t identical, active management was the preferred choice. The amount of research in our industry would seem to suggest that such activities be rewarded. However, finding “good” active managers (and keeping them during the inevitable periods of underperformance) is a daunting task. Thirty years of performance data verify that the cumulative drag of management fees, trading expenses, and agency conflicts are large and that the indexes are tough to beat.

Still, even with its performance advantage, the index fund is no panacea. If prices drift from fair value, even if only from time to time, the traditional index fund, weighting stocks and sectors by their price, will pile ever-increasing amounts into the current favorites of the market. We call such episodes bubbles, and human history is littered with them. The tech meltdown at the turn of the century and the recent real estate downturn are just the latest in a long line of bubbles, subsequently bursting at massive expense to investors. Price weighting ensures investors have maximum exposure to a bubble’s darlings right before they fall off a cliff.

The Fundamental Index concept preserves the many virtues of index funds while contra-trading against the market’s greatest excesses, thereby letting mispricing accrue over time to the investor’s benefit. By delinking price from the portfolio weight, the Fundamental Index method bypasses bubbles. As such, it is a powerful alternative for those disappointed by the hollow promise of active management and yet unsatisfied with the excess of traditional index funds.

In testing this very simple idea—moving from capitalization weighting to weighting companies in accordance with their economic scale—we find remarkable results. In U.S. large companies, we find that the idea adds over 200 basis points per year over a 46-year span relative to the cap-weighted market portfolio. In other countries, we find an average of almost 300 basis points added per year over a 24-year span. In small companies and in global applications, this margin of victory rises to the 300 to 400 basis points range, again over 20- to 30-year spans.

As we move into more speculative markets and markets for which fair value is nebulous indeed, the benefits escalate. In the speculative Nasdaq stocks, the value add leaps to over 600 basis points over the past 33 years. In emerging markets, it soars to 1,000 basis points over an admittedly short 14-year span. Even in the fringes of the bond world, where fair value is less precise than in investment-grade bonds—high-yield and emerging markets bonds—we find 200 to 300 basis points value added. The data are overwhelming. One might well ask how much data a skeptic needs in order to be persuaded.

As many critics love to point out, past success doesn’t presage future success. That’s obviously true. But, based on this logic, we’d never learn a thing from history nor hire an experienced professional because neither the textbook or the resume offered any clues of the future. Still, a worthy question is: How might the Fundamental Index concept fail in the future? If the market makes no distinction between growth and value stocks, paying the same valuation multiples for all companies, then there is no difference between the Fundamental Index and cap-weighted portfolios; the return difference vanishes. But this would clearly leave much opportunity for the thoughtful investor to pay a penny extra for companies that have superior growth prospects.

There’s a middle ground: If the market underpays relative to consensus expectations for expected future growth and overpays for companies that are struggling, then the performance drag of capitalization weighting will be reversed enough to offset the drag created by pricing errors. Such a world is possible, though perhaps implausible.

In this book, we explore the theoretical nuances of the Fundamental Index concept, its historical roots, and its many practical applications. We outline performance characteristics and implementation considerations in U.S. and global equities; small and large companies; niche categories like Real Estate Investment Trust (REITs) and the Nasdaq; and within economic sectors.

I have been blessed to work in the investment arena for over 30 years, with opportunities to explore ideas in global tactical asset allocation, multifactor risk and return models, the linkages between risk and return, and to test some of the core precepts of modern finance—often finding them far removed from reality. Ours is one of a handful of industries that offer so many unique challenges and, in my opinion, prospects to improve our understanding, practice, and, ultimately, our clients’ well-being. But in order to do so, we have to be willing to challenge conventional thinking. I have dedicated my career to uncovering these opportunities for change and improvement, and to sharing my findings with investors through innovative investment products, published research articles, numerous conference presentations, and now a book. Despite all these experiences, this is the first time I have had the privilege of developing an idea that stirred so much controversy and comment, pro and con, from both practitioners and academics, so quickly.

As with so many powerful ideas, this one has many “fathers.” It is built on the foundation of thousands of research papers identifying consistent market inefficiencies, the many theories that form the latticework for modern finance and investing, and the hard work of many, many people.

I’m grateful to my colleagues, most particularly Jason Hsu for carrying out the research that transformed a simple idea into reality. I’m grateful to our advisory panel and others—Keith Ambachtsheer, Peter Bernstein, Brett Hammond, Marty Leibowitz, Burt Malkiel, Harry Markowitz, Marc Rubenstein, and Jack Treynor, to name just a few—for serving as sounding boards as the idea took form.

I’m grateful to our Fundamental Index affiliates—PIMCO, Nomura Asset Management, FTSE (our partner on the FTSE-RAFI index series), IPM, PowerShares, Charles Schwab, Lyxor, XACT Fonder, Assetmark, Cidel Bank & Trust, Claymore, Columbia Management, Parametric, Pro-Financial, and Plexus Group to name a few—for embracing the idea and helping our work to gain traction in the marketplace.

I’m grateful to the people who explored fundamental—and valuation-indifferent—reweighting of the S&P 500 Index, setting a foundation for the acceptance of this idea. Bob Jones of Goldman Sachs Asset Management (GSAM) is the unsung pioneer in this domain, having developed a profits-weighted S&P 500 product in 1990. Sadly, this product never took off for GSAM and was overtaken by the firm’s more conventional enhanced index products.

Subsequent efforts by David Morris and Paul Wood also helped to build the visibility of this line of research. I’m especially grateful to Paul Wood for his efforts—both in his 2003 Journal of Indexes article and in his conversations with us—to lay a foundation for the core principles of the Fundamental Index idea.

I appreciate Jeremy Siegel’s efforts to popularize the concept. While he’s suffered some “slings and arrows” for comparing this work with the efforts of Copernicus in the sixteenth century, his articulation of the “Noisy Market Hypothesis” in the Wall Street Journal is one of the most succinct descriptions of the theoretical foundations of the Fundamental Index concept that I’ve yet seen.

George Keane deserves special gratitude in our journey to develop this important idea. George relentlessly campaigned against the pitfalls of both capitalization weighting and the S&P 500 during the late 1990s. His conviction, persistence, and determination spurred us to take up his challenge to seek a better index solution.

I’m grateful to my coauthors, Jason Hsu and John West, for their respective efforts to assure the academic integrity and the easy flow of the book. I also thank Katy Sherrerd for spearheading the editorial process and marshalling the efforts of Jaynee Dudley, Kate Rouze, and Elizabeth Collins in their extensive editorial contributions, Dan Harkins for his compliance oversight, and Brett Myers and Bryce Little for analytical and research assistance. And I’m deeply grateful to a finance community that so values and encourages the exploration of new ideas.

Lastly, I’m especially grateful to my family for their patience with the lost weekends that are inevitable in the process of writing a book.

—ROB ARNOTT

CHAPTER 1

Efficient Indexing for an Inefficient Market

What could be more advantageous in an intellectual contest—whether it be chess, bridge, or stock selection than to have opponents who have been taught that thinking is a waste of energy?

—Warren Buffett 1985 Berkshire Hathaway Annual Report Chairman’s Letter

For 50 years, the finance community has been in the thrall of an idea known as the “efficient market hypothesis,” a view that price identically equals fair value. The efficient market hypothesis is an idea of seductive simplicity, and it forms the foundation for much of modern finance theory and practice. It is a core principle for the multitrillion-dollar world of index fund management. Without the efficient market hypothesis, most of the theorems and proofs of modern finance come unglued.