Articles

Fundamental Indexing: An Alternative Approach
    By Scott E. Cawood, CFA, CFP; Chief Investment Officer, Arbor Investment Advisors, Fall 2006

History of Indexing
Jack Bogle is widely recognized as the father of index fund investing. After founding the Vanguard Group in 1974, he launched the Vanguard 500 Index Fund in 1975. Today, this fund is the second largest mutual fund with over $100 billion under management. The advantages of indexing are well known: broad diversification, low cost, high tax efficiency and most importantly, returns that in most cases outperform active investing over the long run. Institutional and private investors alike have embraced index investing as a core position in their portfolios. With the advent of exchange traded funds (ETFs), the popularity of index investing has strengthened further.

Capitalization Weighted Indexes
Most indexes (e.g., S&P 500, Russell 1000) are based on market capitalization weightings–the larger (smaller) the market value of a given company, the larger (smaller) its weight in the index. Conveniently, a cap-weighted index fully participates in market moves and automatically rebalances as the values of the resident companies change. A broad consensus agrees that cap-weighted index funds have been an effective alternative to actively managed funds. Morningstar confirms that on average seven of ten active managers fail to beat the relevant index in a given year.

Robert D. Arnott and his colleagues at Research Affiliates posit that there is room for improvement in the traditional approach to indexing. Arnott has challenged the conventional wisdom by exposing a crucial flaw in cap-weighted indexes–the mathematics requires that we overweight all of the overvalued stocks and underweight all of the undervalued stocks. After thirty years of cap-weighted index investing, this notion seems perplexing.

To make things clearer, envision a two stock world in which both stocks have a fair market value of $1.00. Logically, an investor in an index fund would like to own an equal portion of each stock. The challenge is that we can't know the true fair market value of each company. Moreover, the market is not perfectly efficient since stocks routinely trade above and below their (unknowable) fair market value. Suppose that one company is trading for $1.50 and the other for $0.50, even though both have a fair market value of $1.00. The investor in a cap-weighted index will own three times as much of the overvalued stock as the undervalued stock–exactly the opposite of what common sense investing would suggest.

In a mean reverting world, this design flaw in cap-weighted indexes can lead to significantly lower returns. In fact, Research Affiliates confirms that, since 1926, 68% of the top ten stocks by market value underperformed the market average over the following ten years. The cumulative underperformance over these ten years averaged 26%. Unfortunately, 20-25% of a cap weighted index is invested in these top ten stocks, hence the expected drag on returns.

Fundamentally Weighted Indexes
Arnott argues that a valuation indifferent approach is a better alternative. To be specific, fundamental indexing selects, ranks and weights companies based on four financial metrics of each company's size: sales, cash flow, dividends and book value. Research Affiliates computes a "composite value" for each company by equally weighting these fundamental factors. If a company does not pay dividends, the composite value is an equal weighting of the other three factors. After ranking the companies from largest to smallest, the first 1000 names comprise the large company index (the Research Affiliates Fundamental Indexing 1000, or "RAFI 1000"), with each company's composite value determining its relative weight in the index. The intuition behind fundamental indexing is simple and compelling: we should only increase the allocation of a company in the index if its fundamental factors are growing faster than those of its peers.

The empirical data compiled by Research Affiliates is also compelling. The RAFI 1000 outperformed the cap-weighted US 1000 by 2% per year since 1962 (the earliest period with comparable data available). With the power of compounding, a 2% annualized return pickup doubles a portfolio's value in 36 years. Importantly, this excess return was statistically significant (unlikely to be a random event) and came with less volatility. The growth of a dollar chart below further illustrates the superior performance of the RAFI 1000 vs. a cap weighted index of the 1000 largest companies.

A dollar invested in 1962 in the RAFI 1000 would be worth more than twice as much at the end of 2005 as a dollar invested in the cap-weighted US 1000. Though both indexes sharply corrected when the stock market bubble burst in 2000, note that the RAFI 1000 suffered for a shorter period of time and has continued upward to set new highs. The cap-weighted US 1000 has yet to reclaim its high water mark. The historical outperformance has been even more robust for small cap, international and emerging market equities. This outperformance is also consistent across all ten S&P industry sectors.

Let the Debate Begin!
Given Arnott's credentials as Editor of the Financial Analysts Journal, author of over seventy articles for journals such as the Financial Analysts Journal, the Journal of Portfolio Management and the Harvard Business Review, and winner of five Graham and Dodd awards from the CFA Institute, his work and bold statements draw an audience. Research Affiliates is also gaining traction with investors. CalPERS recently allocated $1 billion of its portfolio to the fundamental indexing strategy. Other institutional investors are following suit. For the private investor, eleven ETFs have launched thus far–two that track the RAFI index for large and small U.S. companies and nine sector ETFs. It is logical to expect ETFs for international, emerging markets and REITs to launch in the near future.

To be fair, some well respected critics have stepped forward. Jack Bogle and Burt Malkiel (father of the Efficient Market Hypothesis, author of A Random Walk Down Wall Street) co-authored an editorial in the June 27, 2006 Wall Street Journal titled "Turn on a Paradigm?" The central theme of the Bogle/Malkiel argument is that, "Fundamental indexing will tend to do well in periods when small-cap stocks and 'value' stocks tend to outperform. Thus it is not surprising that most of the long-term excess return attributed to fundamentally weighted portfolios was achieved between 2000 and 2005 alone, one of the best periods in history for the relative returns of dividend-paying stocks, 'value' stocks and small-cap stocks." They further emphasize that, "...we need a longer sense of history...," and that, "...we need to be cautious before accepting any 'new paradigm' that implicitly suggests that the 'old paradigm'–reflected in more than $3 trillion of capitalization-weighted index investment funds–is in error."

A closer look at Arnott's work provides valuable perspective on the Bogle/Malkiel counterargument. The empirical data since 1962 shows that fundamental indexing has outperformed cap-weighted indexing in bull markets and bear markets, recessions and expansions, and in periods of falling and rising interest rates. Bull markets and economic expansions are certainly not the times when we would expect dividend-paying stocks and value stocks to outperform. In fact, Arnott further shows that fundamental indexing outperforms the representative value index in each major asset class, challenging the notion that RAFI is just another value index.

Bogle and Malkiel are indeed correct that fundamental indexing will outperform the most in the aftermath of a stock market bubble. The graph below vividly illustrates when fundamental indexing has led and lagged.

If you consider returns on a rolling 5-year basis, fundamental indexing has underperformed cap-weighted indexing for only very brief periods of time. Notably, this underperformance has occurred during stock market bubbles. This behavior is not surprising, since during periods of rapid and irrational P/E expansions, fundamental indexes will aggressively rebalance away from stocks with large market values relative to their fundamental metrics of revenues, cash flow, dividends and book value. As you would expect, this rebalancing dampens returns in periods of extreme momentum investing.

Bogle and Malkiel claim that most of the outperformance was captured in the last five years. The fair question to ask, then, is, how does fundamental indexing perform if we exclude the aberrant data of the recent bubble? Interestingly, the results are the same. If one excludes the data for the two years that immediately precede and follow the stock market peak in the year 2000, fundamental indexing outperforms by the same 2% per year that was achieved during the full period of 1962 through 2005.

To evaluate the claim that fundamental indexing introduces a small cap bias, it seems most fair to compare apples to apples and look at the smallest companies in the economy. Arnott's research notes that the RAFI 1500 (the next smallest 1500 companies after the RAFI 1000) handsomely outperforms the Russell 2000, Russell 2500 and Russell 2000 Value indexes.

Implications for Investors
Ok, here it comes... ..past performance may not be indicative of future results! However, as Arnott states, "Our research suggests little reason to believe that this pattern will not continue." Knowing that the future is uncertain, there is room for both cap-weighted and fundamentally weighted indexes in investors' portfolios. Since each approach will outperform in certain periods, a mix of the two should enable higher overall returns at lower overall risk, i.e., yet another opportunity to diversify. That said, if institutional dollars substantively embrace the fundamental indexing approach, the marginal trade of selling the Russell 1000 and buying the RAFI 1000 could amplify any outperformance by RAFI relative to its cap-weighted alternatives. Only time will tell.

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Arbor Investment Advisors, LLC. Please remember to contact Arbor Investment Advisors, LLC if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. Please also advise us if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. A copy of our current written disclosure statement discussing our advisory services and fees remains available for your review upon request.