42 of 45 people found the following review helpful:
3.0 out of 5 stars
Past performance is no guarantee of future one, July 20, 2008
This review is from: The Fundamental Index: A Better Way to Invest (Hardcover)
This book written by the strongest advocate practitioner (Arnott) of Fundamental Indexing (FI) is well written. But, you should not confuse a FI manifesto for a balanced analysis on FI vs Market Cap Indexing (MCI). Arnott goes as far as stating that FI has redefined the entire investment Efficiency Frontier (pg. 241) as for any level of risk, he believes FI earns a higher return. And, for any level of return FI reduces your risk. To his credit, Arnott does a good job of addressing the main critiques against FI in chapters 10 and 11. However, for more challenging FI rebuttals, I recommend the articles by Paul Kaplan and Andre Perold.
The logical advantage of FI is unclear. In the Foreword, Harry Markowitz makes an example with a two stock portfolio and shows how stock mispricing will cause MCI to be over weighted in the overpriced stock. When such a stock reverts back to its fair value, MCI suffers a return drag vs FI. But, Andre Perold using Bayesian analysis, takes apart this exact same example because you don't know beforehand which stock is over valued. To further confuse things, Arnott early in the book (page 38) contradicts himself. He states that a MC index does not have a negative Alpha. But, capitalization weighting does. That's not possible. Either they both incur negative Alpha, or they don't (besides the minor cost difference). Later, on page 208 according to his own analysis, Arnott recognizes that with large caps only 1/3 of the FI value added comes from its actual structure. The other 2/3 come from small cap and value tilts.
To clarify this issue, I will review: a) what I expect the difference between FI and MCI to be, b) the historical records, and c) the FI outlook.
Because FI is under weighing growth stocks, I expect it outperforms during Bear markets and underperforms during Bull markets. Because Bull markets are much longer than Bear ones, I expect FI to earn lower returns but with lower volatility. On a risk-adjusted basis the two should earn equivalent returns. When factoring FI higher turnover resulting in higher operating costs and taxes, MCI should come out slightly ahead.
FI historical back tested records are very impressive. Contrary to my expectation, over the 1962 to 2007 period FI outperformed MCI in Bull markets (by a small margin). And it killed MCI by several percentage points in Bear markets. Overall, FI beats MCI by 2 percentage points p.a. (for large cap) while incurring the same risk (same standard deviation). FI beats the MCI for just about any segment of the equities market: large cap, small cap, value, growth, international, country specific (pg. 123), emerging markets, and REIT. The FI advantage increases from 2% to up to 6% as you move into less efficient markets such as emerging markets. Such historical results are not entirely explained simply by FI smaller cap and value tilt. Any higher return is usually associated with much higher risk (but not for FI). Also, FI beats MCI when focusing on either value or small cap stocks only. Thus, something is going on besides small cap value tilt. Arnott states FI superiority is due to the inefficient allocation of MCI that overweighs the growth stocks that suffer the worst returns in Bear markets. But, FI under weights this same growth stocks during Bull markets. What the FI gains during Bear markets, it should give back during Bull markets. But, it did not. It beat the MCI during Bull markets too. The few times the FI fell behind is during short bubbles such as the late 90s dot.com bubble.
Actual live performance of FI funds has been so far not impressive. This contradicts the author's assertion on page 176. That's because my data set extends another 7 months since the book was published. I investigated the two RAFI funds with available public records: RAFI US 1000 (PRF) covering large caps started in December 2005 and RAFI US 1500 (PRFZ) covering smaller firms. The funds history is short, but is a good test as it captures a Bear Market that started in May 2007. Thus, I would expect the RAFI funds to do better than their MC index fund counterparts. I compared PRF and PRFZ with the traditional index funds most correlated with them, respectively Vanguard Large Cap Value (VIVAX) and Vanguard Small Cap Value Index (VISVX). Since inception the RAFI funds have earned the same return (essentially zero) while incurring the same volatility vs their traditional index counterparts. Since May 2007 (beginning of Bear Market), PRF return is - 23.1% vs - 22.7% for VIVAX. (PRF did a bit worst than VIVAX). Meanwhile PRFZ return is - 20.3% vs - 21.9% for VISVX. (PRFZ did better than VISVX). In both cases, those RAFI funds way underperformed a plain total stock market index fund, especially in a Bear market. This short term track record, especially in a Bear market that should favor RAFI funds, does not give you confidence that such funds will duplicate the impressive historical back tested record.
Paul Kaplan suggests already the next step: MCI with boundaries delineated by certain multiple of fundamentals. He calls this a collared index. When a specific stock would bubble its weight within the portfolio would be reduced by the delineated fundamentals boundaries. By doing so you would preserve the advantages of MCI (low cost, diversification) while avoiding excessive concentration in over heating stocks (FI advantage). I hope Kaplan puts this concept into practice.
If you find this book interesting, I recommend the following books that also defy existing investment theory:
Market Volatility,
Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, and
The Misbehavior of Markets: A Fractal View of Risk, Ruin & Reward. If you want to better understand what traditional investment indexing is about, I recommend the classic
A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, Ninth Edition.
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8 of 8 people found the following review helpful:
5.0 out of 5 stars
A must-read for serious investors, May 22, 2008
This review is from: The Fundamental Index: A Better Way to Invest (Hardcover)
The Fundamental Index is a must-read for serious investors. The authors make a compelling case for the use of fundamental index products in a portfolio designed to outperform its benchmark. I was impressed that the authors devoted two full chapters (10 and 11) to addressing opposing arguments. I found Chapter 13 especially useful, as it contains 10-year return forecasts for bonds and equities from one of the world's leading asset allocators. I was so impressed with the quality of the book that I have since purchased a number of copies to share with other investors.
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13 of 15 people found the following review helpful:
5.0 out of 5 stars
A must read for all investors! I love it!, April 30, 2008
This review is from: The Fundamental Index: A Better Way to Invest (Hardcover)
A must read for all investors! I love it!
I personally believe in active management. The market consists of human beings with many imperfections. If we are wise enough, we could certainly take advantage of investors' irrational behavior, and thus earn excess returns. Unfortunately from the investment practice, very few active fund managers, like Warren Buffett, can consistently outperform the market indices over the past decades. It is a difficult task to delivery Alpha.
Mr. Arnott and his colleagues show us that The Fundamental Index is a better way to invest, and could consistently outperform the traditional cap-weighted market indexes. To my surprise, The Fundamental Index is a very simple and intuitive idea which works from developed markets to emerging markets. What's more, the outperformance of the Fundamental Index is statistically significant, economically large, and can be theoretically expected. For example, The Fundamental index (RAFI) US large portfolio outperforms the cap-weighted S&P 500 Index by 2% annually over the period from 1962 to 2007. The emerging-market fundamental Index portfolio outperforms the cap-weighted MSCI EM Index by more than 10% annually over the period from 1994 to 2007. Imagine that, if we can consistently deliver an Alpha by 2% annually, over a 36 year period, we would double our assets! (Not to mention a 10% Alpha over a 13 year period!)
The Fundamental Index preserves the virtues of the cap-weighted index such as transparency, diversification, low turnover and high capacity, but overcomes the price inefficiency problem. The cap-weighted index portfolio tends to systematically overweight the overpriced stocks and underweight the underpriced stocks. That is the reason why the Fundamental Index outpaces. I am so excited that Mr. Arnott can share the investment Holy Grail with all investors. I deeply believe that "the Fundamental Index idea will be the fastest new investment idea to reach $100 billion in assets in history!" I strongly recommend that every investor should read this book.
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