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Two words explain why no pension fund has yet installed a fundamental indexing strategy as the core of its equity portfolio, according to one of the concept’s originators, Rob Arnott – “maverick risk”. About the closest a fund has come is CalPERS, which views fundamental indexing as an enhanced index play, and recently approved a further expansion of its US$2 billion commitment to the concept. But that’s a drop in the ocean in the context of a US$177 billion system.
Arnott is the chairman of Research Affiliates, which unveiled fundamental indexing in 2004 and has been criticised by efficient market theorists ever since. Fundamental indexing ignores the market capitalisation of a stock, and instead prioritises its holdings according to “real economy” factors like a company’s level of sales, book value, dividends and earnings. Notables like AQR founder Cliff Asness have dismissed the concept as repackaged value indexing, however Arnott said this reflected a “cap-weighted centric” view of the world, because cap-weighted indexes will always load up on growth stocks trading above the market multiple.
Money has been run using Research Affiliates Fundamental Indexes (RAFI) since 2006, implemented by FTSE, and FTSE/RAFI’s All World 3000 and Developed 1000 indices beat their capweighted counterparts that year, as well as in 2007 and so far in 2009. (The FTSE/RAFI All World 3000 had returned 4.13 per cent this year to the end of April, against a loss of 0.07 per cent for the MSCI All Country World. In the same comparison starting from December 31, 1999, a backtested version of the FTSE/RAFI returned 4.52 per cent against a loss of 2.27 per cent for the MSCI index, although it enjoyed slightly lower standard deviation.)
Arnott took it as evidence of the depth of feeling against fundamental indexing when slight underperformance in 2008 – “a relentlessly wretched year for value all over the world” – was seized on by detractors as proof the concept did not work. Arnott was in Australia last month to support the recent launch of RealIndex Investments, an alliance between Research Affiliates and Colonial First State which has brought four funds to market – Australian shares, Australian small caps, global shares and global shares hedged – based on the RAFI ‘enhanced’ methodology, which in addition to the bedrock measures of sales, cash flows, book value and dividends, also ranks companies on their quality of earnings and debt coverage.
