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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.
The bedrock measures are rebalanced annually, but the enhancements rely on fresh data and are hence
rebalanced quarterly. Despite their record of
outperformance, Arnott said he
was not surprised that no fund
had replaced its capweighted core. “If you’re managing a large pool of money, there are limits to how far you can stray away from convention. It’s sometimes referred to as
maverick risk. Most people don’t
want to take on enough maverick
risk that an idea or strategy
would be abandoned in one bad
year.
So even those who view fundamental indexing as “better beta” are likely to want to have diversified
beta”. However he takes
consolation from the fact it
took “about fifteen years” from
the introduction of a Standard & Poor’s cap-weighted index of US stocks in 1957 for any money to actually be managed on it, and “another fifteen years before the amount of money that’s fundamentally indexed today was
managed on a cap-weighted basis”. There is US$20 billion fundamentally indexed globally today (out of a total market cap of US$40 trillion)
but Arnott said he would be “stunned”
if there was not US$30 billion
in RAFI strategies by the time
2009 was out.
FTSE is doing its
bit for the growth of the
strategy in Australia,
with the first Australian
FTSE/RAFI indices about to
become available for implementation. As the concept grows in popularity, it has also become cheaper, for
instance Invesco Powershares
recently dropped prices on its
range of FTSA/RAFI exchange
traded funds from 60 bps to 39
bps, once assets under management surpassed US$1 billion.
Arnott
accepts that fundamental indexing
remains more expensive than cap-weighted
indexing. He estimated the RAFI range is priced anywhere from “half to one-third” of the
equivalent active strategy,
while cap-weighted indexing is
more like one-tenth. But he says
the gap is closing. “I was in a
debate with [Vanguard founder
and trenchant critic of fundamental indexing] Jack Bogle last fall, and he was saying ‘your
strategies are so expensive’. I
turned to him and said ‘Jack,
when you first launched your S&P
500 index fund did you charge seven
basis points?’ Discussion over.”
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