Arnott Talks Fundamental Indexing, Bond ETFs, And More

by on March 28, 2011 | ETFs Mentioned:

Rob Arnott is the founder of Research Affiliates, a global leader in innovative investing and asset allocation strategies. The firm is perhaps best known for its role in developing fundamentally-weighted indexes that utilize the RAFI methodology. This strategy involves selecting and weighting securities by fundamental measures of company size, as opposed to market capitalization. The methodology captures many of the benefits of passive investing—such as transparency, objectivity, broad economic representation, and diversification—with less exposure to pricing errors and fads. Several ETFs are linked to RAFI indexes, including several PowerShares products and a long/short ETF from ProShares.

Rob recently sat down with ETF Database to talk about some of the limitations of traditional cap weighting methodologies, why alternatives have been slow to catch on, and what fundamental indexing can bring to the bond space:

ETF Database (ETFdb): Why do you think market-cap weighting is the dominant force in the equity ETF space?

Rob Arnott (RA): Well a lot of it has to do with history. The first major cap weighted index was the S&P 500, launched in 1957. And only five years after that the efficient market hypothesis showed up on the scene saying it’s a waste of time to pick stocks. Two years after that, the capital asset pricing model proved that if markets are efficient the cap weighted benchmark is the best risk adjusted portfolio you can own. So that laid the foundation for cap weighted indexing.

We’re in an industry with a lot of inertia. Things change slowly. It took 30 years for cap weighted indexing to go from nothing to about 15% of the global market share. The notion that it would take different approaches to indexing a long time to gain traction is not that surprising, so of course the majority of indexed assets are going to be cap weighted for a very long time to come [RAFI ETF Turns Five, Celebrates Results].

ETFdb: You mentioned some of these alternatives–why have they popped up? What have been some of the frustrations and potential drawbacks with this idea of transforming a cap weighted index into an investable asset?

RA: Cap weighting has a lot of merits; it has vast liquidity, ease of trading, and representativeness of the whole market. Trading costs are low, fees are low, and there is a whole host of advantages. The idea of indexing in a fashion that does not involve cap weighting is relatively new. To be sure, the S&P introduced the equal weighted indexes back in 1990. But they never gained a lot of traction, ironically, until after we introduced the fundamental index idea. I think what we did is in a sense open Pandora’s Box and reveal that there are whole hosts of ways that people can choose to index. We are starting to see that tidal wave in alternatives develop. I see no evidence that this interest is slowing–indeed quite to the contrary. We are seeing that the rate of growth seems to be increasing with each passing year [Russell, RAFI Team Up On Fundamental Indexes].

ETFdb: It seems that 2010 demonstrated to investors that the choice of weighting methodology may seem like a minor decision, but in reality it can have a pretty significant impact on bottom line returns. Do you agree with that, and does your research validate that suggestion?

RA: That is absolutely correct. The choice of weighting scheme matters tremendously. If you weight companies in accordance with market capitalization then you are in effect investing more in the companies with the highest multiples, greatest popularity, and the companies that are seen as growth opportunities and have lots of momentum to them. If one wants to invest in a popularity-weighted, growth-tilted, momentum-chasing strategy, then cap-weighting achieves that beautifully. And there is nothing wrong with that; over many years it has performed awfully well, but one can do better.

I think the key is to break the link between price of a company and its weight in a portfolio. If the price is high, why should you own more? A lot of these new approaches do break that link and so they have a shared alpha engine in breaking the link between the price of stock and the size of our commitment. Why should we own twice as much just because it doubled in price?

ETFdb: You talked about breaking the link between price and the weighting in an index. Explain how the RAFI products that your company has developed do just that.

RA: Well, broadly RAFI involves selecting and weighting companies in proportion to the economic footprint of the company: the size of its business, not its market cap and essentially not what the market thinks will be the future size and success of the company, just how big it is now. There are a lot of ways to measure a company’s size; you can do it based on sales, profits, cash-flow, book value, dividends. There are also a host of other measures including some that aren’t even economic measures–for example the number of employees. What’s interesting is that they all work. And they all work approximately as well as one another. There is no single approach that is utterly dominant.

In the US, sales weighting has slightly the highest returns, but also the highest volatility. Dividend weighting has the lowest value add, but it still beats cap weighting, and it has the lowest risk. The risk-return trade-off doesn’t appear to exist even within fundamental indexes. But the idea behind a fundamental index was one of weighting companies according to their size in the economy, so that instead of looking at an index that looked like the composition and structure of the stock market, you would instead have a portfolio that looked like the composition and structure of the economy.

It is only after we began doing the work that we realized that by breaking the link with price we were adding material value, and that value came from contradicting with the markets constantly shifting speculations, expectations, fads, bubbles, and crashes.

ETFdb: That last point you made regarding bubbles and crashes—we have seen a number of examples of that recently haven’t we?

RA: Sure. The scale of the financial services industry in the US economy has been fairly steady for the last decade. It’s the single biggest industry in the private sector, outside of government. It’s enormous.

The cap weighted market took the weight attached to financial service stocks down rather low at the peak of the tech bubble, well under its economic footprint. And it chased the financial successes of these companies during the real estate bubble to a point where financial services comprised as much as 27% of the stock market during 2007. And then of course when there were problems, and the sector crashed to a point where it was less than 10% of the market by early 2009.

It’s interesting whether you look at the size of the financial services sector based on percent all dividends that are paid, or percent of all profits earned, or book value, or percent of all sales and revenues. What you find is that it winds up being 20-25% of the US economy over the course of the entire last decade. So when it got to 27%, the market was paying a premium for financial services and was betting they would grow even larger. And then just two years later it was betting that the financials would continue to implode and that many of these businesses would go bust. But what the market overlooked was the fact that in any crisis, there are consequences and with each failure in the financial services community the survivors had more pricing power, more profit potential, and less competition than they had previously.

Now I would argue that’s why Goldman Sachs had such wonderful success in 2009 and 2010. Their competition basically imploded, opening the door for their successes. A cap-weighted methodology will overlook the fact that a sector that is struggling may regain its footing, and it will also overlook the fact that a sector that is enjoying stellar success could subsequently shrink. And so by contra-trading against these constantly changing opinions, you wind up adding value, and that’s where the fundamental index shines [Why Weighting Methodologies Matter When Choosing An ETF].

ETFdb: We have talked primarily about the RAFI methodology as it relates to equities, but it can also be applied to the fixed income market. PowerShares’ Fundamental High Yield Corporate Bond Portfolio (PHB) seeks to replicate a RAFI index. Could explain how that product might differ from some of the other fixed income indexes?

RA: When you think about capitalization weighting in stocks the drawbacks are fairly evident. When you talk about cap weighting in bonds, the drawbacks are flagrantly obvious.

With cap weighting, consider that Australia has three times the GDP of Greece, and Greece has three times the debt burden of Australia. Why should we want to own three times as much in Greek debt as Australian debt? In fact, Australia’s ability to service debt is at least three times that of Greece, and so wouldn’t it make more sense to have an index for bonds that weights countries’ bond debt in accordance with GDP and other measures of the economic footprint of a country?

This is what the fundamental bond strategies will do. PowerShares was intrigued by this idea and decided to convert their high-yield bond strategy to a fundamental high-yield bond index, and they did so last July. It’s very exciting, when you go back historically the fundamental index applied to high-yield bonds adds over 300 basis points per year going back for the 14 years that we were able to test. It is hard to imagine adding over 300 basis points annually, but that is what the historical records suggest. On the equities side, we found that the historical record showed that it has added on live indexes typically 2-4% all over the world, it has added 2-4% per annum on live assets in funded accounts over the past five to six years.

What’s interesting is that it is during a time when value underperformed. If this strategy–which many people describe as simply a value tilted strategy–wins when value is losing, then something else is going on. That something else is rebalancing and contra-trading against the markets changing views

ETFdb: Thanks very much for sharing your thoughts.

For more reading on indexing strategies and RAFI weighting, see:

[For more ETF insights, sign up for our free ETF newsletter.]

Disclosure: No positions at time of writing.