Customer Reviews

The Fundamental Index: A Better Way to Invest

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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.

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.

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.

I am a relatively well known fan of the fundamental index approach. Rob and his co-authors have a great turn of phrase which makes this book a pleasure to read. The discussion of how the value/size tilt is a result of contrarian against the cap weighted index is particularly insighful. I know Cliff doesn't approve, but I can't help but be impressed when someone offers a really cheap way of investing in a sound strategy.
To my mind this is a book that all inveswtors hsoudl read, be they active or passive. Regardless of the way in which you invest, you should find something to make you think in this excellent tome.

This book makes a compelling case to consider another way to give investors a broad market exposure at low cost and low turnover, other than cap-weighted indexing. It does not argue that there is no role for active investment, but that it is extremely difficult to find active investors who can outperform consistently over time.

Index investors have always faced a dilemma: they know that on average, active investment management will underperform a cap-weighted index, after allowing for fees. But cap-weighting a portfolio leads to more money weighted towards more expensive stocks, and less towards cheaper stocks, due to the direct link to price. As the market corrects towards the intrinsic value of the stocks, the portfolio will suffer.

The book proposes a method which weights stocks based on their economic fundamentals, such as sales, book value and dividends, rather than market price, and the results show consistent outperformance.

I find this such a compelling and simple idea, and the book provides enough evidence for the most academic and thoughtful market participants to wade into the debate.

Take a simple example (this is my own, not from the book). A restaurant owner knows things like total sales, expenses and cash flow, and can tell how well it is doing, and the value of the business. However, if it was a listed company, its value would be reacting to market rumours on staff leaving, perceptions of the effect of a wet summer, reports on potential competitors, criticims of the food, whatever. And the market would trade the stock based on all these factors which may or may not have an impact on the intrinsic value. Yet a cap-weighted index would hold the stock based on rumour and guesses about the future. I'd rather just use the economic fundamentals of the business.

It is difficult to refute the book's argument that a cap-weighted index has a direct structural link to any pricing error, and since the true value of a stock is the net present value of decades of future cash flows, which must be unknown, there must be pricing errors. The market is not efficient, as it cannot know everything. As these errors will be random, the cap-weighted index will have more than half the portfolio in the overvalued companies, and less than half in the undervalued companies, because the weight is linked to the price. I found this conclusion especially revealing.

The only time when a cap-weighted index may outperform a fundamental index is during a major bull run, such as 1999, when growth stocks are continuously marked up. However, this is when I least want to put more into the expensive growth stocks, which cap-weighting does.

This book is not an academic exercise, despite the backgrounds of its authors, but is easy to read and understand. It illustrates its points with examples we can all identify with, and directly addresses the criticisms of its approach with a degree of humour. It certainly delivers a few 'ah-ha' moments.

If I have one general criticism, it is that a relatively simple idea takes 300 pages to address. I'm sure this is because the authors are producing the first comprehensive book on an idea which could seriously change investing markets, and they try to cover all bases. But I did felt like saying, "Yes, I already got that" a few times.

With most investments actively managed and the rest in cap-weighted indexes, the ideas in this book challenge orthodoxy. But that's always a good thing.

This book contains a good overview of the basic arguments for and against The Fundamental Index in a very readable format. For those who have followed the debate in the finance journals, there will be little new here and the book does not address the formal mathematical models of Fundamental Indexing that have been introduced in various papers from Arnott & Hsu. However, the data and arguments are well organized, with the book proceeding from an introduction of the concept, through the historical data and ending with a balanced overview of the arguments for and against.

The book is more than just a pitch for a particular investment strategy, the issues raised in The Fundamental Index touch upon the empirical foundations (or lack thereof) of Modern Portfolio Theory and will force any investor, regardless of whether they use the approach or not, to think more carefully about their basic assumptions about the equity markets.

For a layperson looking for depth and insight into the equity markets, this book would make an excellent supplement to a more general work such as Burton Malkiel's Random Walk Down Wall Street.

The books keep rolling in; I keep reviewing. Given that I am a generalist, perhaps this is a good task for me. Before I start for the evening, though, because I know the material relatively well, I skimmed the book, and read the parts that I thought were the most critical.

The Religious War Over Indexing

Passive investors are often passionate investors when it comes to what they think is right and wrong. For market cap or float-weighted indexers:

* The market is efficient!
* Keep expenses low!
* Don't trade fund positions!
* Fundholders buy and hold!
* Tax efficiency!
* Weight by market cap or float!

For fundamental indexers:

* The market is inefficient (in specific gameable ways).
* Keep expenses relatively low.
* Adjust internal fund positions as valuations change!
* Fundholders buy and hold!
* Relative tax efficiency!
* Weight by fundamental value!

Some of the arguments in Journals like the Financial Analysts Jounrnal have been heated. The two sides believe in their positions passionately.

For purposes of this review, I'm going to call the first group classical indexers, and the second group fundamental indexers. The first group asks the following question: "How can I get the average return out of a class of publicly buyable assets?" The answer is easy. Buy the same fraction of shares of every member of the class of assets. The neat part about this answer, is everyone can do it. The entirety of shares could be owned in such a manner. Aside from buyouts and replacements for companies bought out, the turnover is non-existent. Net new cash replicates existing positions.

The fundamental indexer asks a different question, namely: "What common accounting (or other) variables, relatively standard across companies, are indicators of the likely future value of the firm? Let's set up a portfolio that weights the positions by the estimated future values." Estimates of future value get updated periodically and the weights change as well, so there is more trading.

Now, not all fundamental indexers are the same. They have different proxies for value -- dividend yield, earnings yield, sales, book value, cash flow, free cash flow, etc. They will come to different answers. Even with the different answers, not everyone could fundamentally index, because at some point the member of the asset class with the highest ratio of fundamental weight as a ratio of float weight will be bought up in entire. No one else would be able to replicate the fundamental weightings.

So, why all of the fuss? Well, in tests going back to 1962, the particular method of fundamental indexing that the authors use would beat the S&P 500 by 2%/year. That's worth the fuss. Now, I have kind of a middle position on this. I think that fundamental indexing is superior to classic indexing, so long as it is not overdone as a strategy. Fundamental indexing is just another form of enhanced indexing, tilting the portfolio to value, and smaller cap, both of which tend to lead to outperformance. It also allows for sector and company-level rebalancing changes from valuation changes, which also aids outperformance. In one sense fundamental weighting reminds me of Tobin's Q -- it is an attempt to back into replacement cost. Buy more of the assets with low market to replacement cost ratios.

But to me, it is a form of enhanced indexing rather than indexing, because everyone can't do it. Fundamental Indexing will change valuations in the marketplace as it becomes a bigger strategy, wiping out some of its advantages. The same is not true of classic indexing, which just buys a fixed fraction of a total asset class.

Though the book is about fundamental indexing, and the intellectual and market battle versus classic indexing, there are many other topics touched on in the book, including:

* Asset Allocation -- best done with forward looking estimates of earnings yields (another case of if everyone did this, it wouldn't work.. but everyone doesn't do it. Ask Jeremy Grantham...)
* The difference to investors between dollar vs time weighted returns by equity style and sector. (Value and Large lose less to bad trading on the part of fund investors... in general, the more volatile, the more fund investors lose from bad market timing.)
* A small section on assumptions behind the Capital Asset Pricing Model, and how none of them are true. (Trying to show that a cap-weighted portfolio would not be optimal...)
* And a section on how future returns from stocks are likely to be lower than what we have experienced over the last half century.

One more note: I finally got how fundamental weighting might work with bonds, though it is not explained well in the book. Weight the bond holdings toward what your own models think they should be worth one year from now. That's not the way the book explains it, but it is how I think it could be reasonably implemented.

The Verdict

I recommend the book. The authors are Bob Arnott, Jason Hsu, and John West. At 260 pages of main text, and a lot of graphs, it is a reasonable read. The tone is occasionally strident toward classic indexing, which to me is still a good strategy, just not as good as fundamental indexing. (It sounds like Bob wrote most of the book from a tone standpoint... but I could be wrong.)

Who should buy this book? Academics interested in the debate, and buyers of indexed equity products should buy the book. It is well-written, and ably sets forth the case for fundamental indexing.

Length:: 4:15 Mins

I believe the book is a must read for professional investors as well as non-professionals, advisors, trustees and most certainly the academic community. It offers a (deceptively) simple explanation to a series of widely debated issues in modern portfolio construction. While I wouldn't dare entering into a debate with any of the rather well-known critics of the concepts I would propose that they all read the book carefully and contemplate the principle known as Occam's razor while doing so; "Occam's razor (sometimes spelled Ockham's razor) is a principle attributed to the 14th-century English logician and Franciscan friar William of Ockham. The principle states that the explanation of any phenomenon should make as few assumptions as possible, eliminating those that make no difference in the observable predictions of the explanatory hypothesis or theory." (Quote from Wikipedia) The Fundamental Index concept as such may not be new, other will have to be the judge of that, but at least I know of no other formalization of the concept, nor of any other text offering the richness in its explanations of the sources and applications of the concept. (Disclosure: I am on record as being a supporter of the concept and I work for a firm that is a Research Affiliates, LLC, licensee.)

The basic premise of the The Fundamental Index: A Better Way to Invest is that an efficiency weighted portfolio has and will over the long run outperform a market cap weighted portfolio. The underlying assumption is that the efficient market hypothesis does not hold true, and thus it is possible for errors in equity share prices to occur and this will lead to errors in stock weights for traditional market cap indexes.

The Fundamental Index combines 4 constructs--a company's sales, cash flow, book value, and dividends--to weight companies in an overall index. Companies that do not pay dividends are not penalized in the index and are weighted based on the other 3 elements. The ultimate goal is to build an index that reflects a company's economic footprint rather then its market cap. During periods where mis-pricing in markets has been most egregious, such as the Dot-Com Bubble, high growth companies attain heavy weighting in a market cap index. Conversely, the Fundamental Index rebalances weightings based on the 4 constructs mentioned; therefore, it avoids overweighting companies whose fundamentals have not yet caught up to its valuation.

The Fundamental Index: A Better Way to Invest is a must read. The idea is fairly simple, yet revolutionary in an investing world which has so heavily depended on market cap weighted indexes. However, the most impressive part of the book is not the idea itself but the empirical evidence presented by the authors, Rob Arnott, Jason Hsu, and John West. The authors go to great lengths to present historical performance for the Fundamental Index in a wide variety of global markets, in a variety of bull and bear markets, over several decades. The evidence is compelling; in addition, they make the case that we are entering an era of lower returns (an impressive argument when you consider the book was published in early 2008 prior to Lehman) and they show that the Index has historically performed well in such an environment.

The Fundamental Index: A Better Way to Invest is published by Wiley and is currently available on Amazon for less then $20 - a steal when you consider the content may change the way you invest.