Quarterly Newsletter: October 2006

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Strong Quarter
At last, the Fed paused in its campaign to increase short term interest rates, with the target Fed Funds rate holding steady at 5.25% after seventeen consecutive rate hikes. Virtually all asset classes responded positively in a strong third quarter. Real Estate led the way (+9.3%), followed by US Large Cap Equities (+5.1%), Emerging Markets (+5.0%) and International (+4.0%). US Small Cap Equities were flat (+0.4%). On the back of decreasing intermediate term bond yields, the Lehman Aggregate Bond Index gained 3.8%. Economic data reflect decelerating growth, led by the broadening weakness in housing markets.

Advantages of Indexing
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 are based on market capitalization weightings–the larger (smaller) the market value of a given company, the larger (smaller) its weight in the index. Robert D. Arnott and his colleagues at Research Affiliates posit that there is room for improvement in the traditional approach to indexing. Arnott is very well credentialed 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. He points out that a cap-weighted index (e.g., S&P 500, Russell 1000) over weights all over priced stocks and under weights all under priced stocks.

Fundamentally Weighted Indexes
Arnott argues that a valuation indifferent approach is a better alternative. He suggests using indexes that weight stocks based on four financial metrics of each company's size: sales, cash flow, dividends and book value. 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 appears to prove the case. The RAFI 1000 outperformed the cap-weighted US 1000 by 2% per year since 1962 (the earliest period with comparable data available). 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.

Let The Debate Begin!
Some well respected critics have stepped forward. Jack Bogle (father of cap-weighted indexing, founder of The Vanguard Group) and Burt Malkiel (father of the Efficient Market Hypothesis, author of A Random Walk Down Wall Street) argue that fundamental indexing creates a bias toward value stocks and small cap stocks. They also contend that fundamental indexing captured most of its excess returns between 2000 and 2005 when value stocks and small cap stocks were in favor.

A closer look at Arnott's work provides valuable perspective on the Bogle/Malkiel counterargument. The empirical data since 1962 show 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.

Bogle and Malkiel are indeed correct that fundamental indexing will outperform the most in the aftermath of a stock market bubble. The graph to the right 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 expansions in price to earnings multiples, 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.

Interestingly, 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.

Implications For Investors
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.

Please contact us if you would like to receive a more in depth review of fundamental indexing.

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.

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