Wealth Manager

The market is flush with new indices and related ETFs
and index mutual funds that claim an edge over their
predecessors. Some date the new world of indexing to
2003, with the launch of the first equal-weighted S&P 500
ETF: Rydex S&P 500 Equal Weight (NYSE: RSP). True,
Morgan Stanley had been running an equal-weight S&P
index mutual fund since 1987 (Morgan Stanley Equal
Weighted S&P 500: VADBX). But for many, the Rydex ETF
signaled a fresh start for rethinking and reinventing index
design and, perhaps, asset allocation, too.

Certainly since 2003 there has been an explosion of new
benchmarks with grand ambitions. That includes efforts
to combine passive indexing with alternatives to the
traditional methods of weighting securities by assigning
stocks a share in an index according to their market value.
Otherwise known as market-cap weighting, this was—and
is—the old standby used for the S&P 500, Russell 3000,
etc. Now, although there is a growing list of new ideas in
indexing, expectations may be highest for what is known
as fundamentally weighted indices. Broadly speaking, this
group uses earnings, dividends and other “fundamentals”
for weighting stocks.

Using one or more of the fundamental measures for
designing equity indices represents a “huge paradigm
shift” for indexing, wrote Wharton professor Jeremy Siegel
in a widely quoted Wall Street Journal op-ed in 2006. And
while the prospects for the new indices continue to be
hotly debated, that hasn’t stopped several high-profile
academics and consultants from throwing their intellectual
weight on the side of the fundamental indices. Nobel
Laureate Harry Markowitz of portfolio-optimization fame
has written in favor of the idea. So has Jack Treynor, one
of the originators of the 40-year-old capital asset pricing
model (CAPM), which is the basis for using cap-weighting
as the default choice for index design.

But that was then. There’s a new kid in town, and it’s time
to upgrade, Treynor, Markowitz and others advise. Investors
who agree can choose from a growing list of products tied
to equity indices that distinguish themselves by shunning
market-cap weighting. Extending the fundamental indexing
concept to other asset classes is reportedly also under study.
As a result, revising asset allocation strategies may be the next
big thing in indexing.

Meanwhile, old habits still die hard in 21st century finance.
Cap-weighted equity indices remain the overwhelming preference
for strategists who favor betas in money management. A
half century of financial economics isn’t easily overturned—
although that doesn’t stop some from trying.

And no one is trying harder than Robert Arnott, chairman
of Research Affiliates in Pasadena, Calif. Three years ago,
Arnott and two co-authors laid out their case for an equity
index that weights stocks based on book value, sales, cash flow
and dividends (“Fundamental Indexation,” Financial Analysts
Journal, March/April 2005). This foursome, the paper asserts,
goes a long way in correcting the “pricing errors” embedded in
cap-weighted indices. As evidence, the paper cites a back test
that shows the fundamentally weighted index for U.S. stocks
outperformed a comparable cap-weighted benchmark by an
annualized 197 basis points for the 43 years through 2004, and
with similar volatility to boot.

Reportedly, the source of the superior performance in
the Fundamental Index concept comes from sidestepping
cap-weighting’s bias for holding overvalued growth stocks at
the expense of undervalued value stocks. “Mathematically, cap
weighting assuredly gives additional weight to stocks that are
currently overpriced relative to their (unknowable) discounted
future cash flows (the true fair value) and reduces weights in
stocks that are currently trading below that true fair value,”
Arnott and his associates write. (A brief digression: Research
Affiliates has claimed its Fundamental Index label is a registered
trademark, thus the firm’s preference for capitalizing the name.)

Like most new ideas in finance, this one has spawned its
share of dissent and debate. Much of the criticism is less about
the results than about labels—namely, that fundamental
weighting is really value investing by a different name. Recent
issues of the Financial Analysts Journal highlight some of the
more pointed critiques, which in turn have elicited rebuttal
from the defenders. (See “Fundamentally Flawed Indexing”
in November/December 2007 FAJ; and “Why Fundamental
Indexation Might—or Might Not—Work,” as well as letters to
the editor in March/April 2008 FAJ.)

The jury may still be out on this debate, but as a business,
the fundamental benchmarking idea is rolling along. A mere
two- and-a-half years old, the first fundamentally weighted
index ETF (PowerShares FTSE RAFI US 1000, NYSE: PRF) had
net assets at a tidy $850 million as of this past March, according
to Morningstar Principia. Globally, roughly $20 billion in
ETFs, mutual funds and other accounts track Research Affiliates’
indices, which now come in a rainbow of broad market,
industry, domestic and foreign equity indices offered through
several product vendors. There’s also an expanding list of ETFs
based on other fundamentally oriented indices, including a
suite of funds weighted by dividends and earnings via Wisdom
Tree, which claims the aforementioned Jeremy Siegel as senior
investment strategy advisor. And the new players keep coming,
such as RevenueShares Investor Services, which earlier this
year launched a trio of ETFs that weight stocks by revenues.

Meanwhile, Arnott says that Research Affiliates is considering
an expansion of the firm’s indexing methodology to
bonds. Farther down the road, REITs and even commodities
are possibilities, he tells Wealth Manager.

Looking down that road, one can imagine building multiasset
class portfolios exclusively with fundamentally weighted
indices. In turn, that suggests moving asset allocation to the
next level, so to speak. In fact, the next level has already arrived
for global equity portions of asset allocation.

If the new indices live up to the billing, their use in asset
allocation holds out the possibility of boosting stability and
visibility in the overall portfolio relative to building portfolios
with cap-weighted indices. The reasoning is tied to the basic
proposition of fundamentally weighted indices and their
claim of offering a smoother ride and higher returns than
cap-weighting. If this enhancement proves durable, more
of the rebalancing work that’s now typical—and perhaps
necessary—with cap-weighted indices will come pre-packaged
in fundamentally weighted benchmarks.

The implied rebalancing bonus of fundamentally weighted
indices may come in handy, given the evolving state of investment
theory. As discussed in the May 2008 issue of Wealth
Manager (“Back to the Future—Again,” p. 66), the finance
literature now supports the case for a relatively dynamic asset
allocation. That’s based on the accumulating evidence in the
academic literature that expected returns are predictable to
a higher degree than previously recognized. Markets go to
extremes at times, which means that prospective risk premia
fluctuate. Higher dividend yields, for instance, imply higher
expected returns, and vice versa. The point is that allocations
to the various asset classes should rise and fall in accordance
with the current fundamental outlook.

The source of the higher predictability is hotly debated.
Some say it’s a function of market flaws or investor irrationality.
Others speak of a revised efficient market hypothesis that
offers a fluctuating risk premium driven by economic fundamentals.
In either case, the implication for investment strategy
is clear: Asset allocation should be dynamic to capitalize on
the return predictability. In contrast, an older view of modern
portfolio theory and EMH suggests keeping asset allocation
static, based on the assumption that markets are completely
unpredictable, and so expected return is constant.

Not so, financial economics now counsels. Markets are not
completely predictable, of course. But expected returns are
partially visible, we’re told, which implies that asset allocation
should be partially active. Certainly that’s true for asset allocation
strategies using cap-weighted indices, which are susceptible
to the extremes of market conditions and investor sentiment.

But what if we’re using fundamentally weighted benchmarks?
These indices are designed for a smoother ride with a
comparable and perhaps higher return relative to cap-weighted
benchmarks. Certainly in the case of Research Affiliates’
indices the intent is to provide a more efficient sampling of
the economy’s footprint via a diversified basket of stocks. All
things equal, running asset allocation strategies with fundamentally
weighted ETFs and mutual funds implies a less-active
rebalancing program compared with cap-weighted products.

Arnott and two Research Affiliates associates have considered
the strategic possibilities in The Fundamental Index: A Better Way
To Invest (Wiley, 2008). As the graph on the previous page—from
the book—illustrates, Fundamental Index strategies are said to
offer three basic opportunities to “reshape return expectations”
when the benchmarks replace cap-weighted indices by:

1) lowering risk without lowering expected return, or
2) raising expected return without raising risk, or
3) raising risk levels by increasing equity allocation but
without increasing downside risk.

Assuming Fundamental Indexes deliver as promised, all
of the above are possible because of the enhanced stability
in capturing the equity market’s expected return. In short, a
strategic use of Fundamental Indexes implies a lesser degree
of active asset allocation compared to the use of cap-weighted
indices, while remaining true to current academic thinking.

It’s a bit ironic that the Fundamental Index ideal revives the
case for more stability in asset allocation. Recall that relatively
stable, unchanging asset allocation strategies apply only under
the old view of market efficiency—i.e., market prices equate
with fair value. Fundamental Indexing rejects the old view of
market efficiency. Yet this solution leads one back to an asset
allocation approach that’s closer in spirit to a world defined
by a classic definition of market efficiency. In some respects,
what’s old is new again.

Ironic, perhaps, but not necessarily surprising. We’re told
that Fundamental Indexing effectively seeks to reinstate some
of the pricing efficiency in the capital markets that is lost with
cap-weighted indices. If true, it should be no wonder that asset
allocation via Fundamental Indexing offers the potential for
bringing us closer to a less-dynamic strategy than would be
appropriate with cap-weighted indices.

So far, so good. But the question remains: Will fundamentally
weighted indices live up to their marketing? Yes, the
analysis by Arnott and others is compelling. At the same time,
the history of empirical research is littered with studies that,
in varying degrees, performed better on paper than in the real
world. Will fundamental indexing fare any better? Unfortunately,
it’s still too early to say.

Just as the first experiments in indexing required time to
prove their worth in the real world, so too must fundamental
indexing go through economic-cycle stress testing, with actual
dollars on the line. In fact, the testing is unfolding as we speak.
Stay tuned.