Many fundamental indexes really are a value investor's dream. After all, they are based on the so-called fundamentals of a company: sales, income, book value and dividends. By weighting the universe of equities by valuation metrics instead of only market capitalization, fundamental indexers are challenging the prevailing orthodoxy of the asset-allocation models of the past three decades. So, too, do these indexes have an impact on how you allocate your clients' other assets. Let's face it: Fundamental ETFs are more of a strategy than an index. That's because an ETF based on high dividends may be appropriate one year and not a losing bet the next.
Of course, the point of fundamental ETFs is compelling to many advisors. But the question becomes, When do you use them, and how much? Fundamental indexes are trying to solve the problem of irrationality in an index. In the late 1990s, many advisors complained that the S&P 500 stock index had morphed from a basic exposure to the U.S. economy to a proxy for growth, overweighted by high-flying tech stocks.
A couple of years ago, Rob Arnott, chairman of fundamental indexing pioneer, Research Affiliates, together with collaborators Jason Hsu and Philip Moore, published an article in the Financial Analysts Journal entitled, “Fundamental Indexation.” They showed that market-capitalization indexes tend to overweight large growth stocks (which is fine when that style is working). But Arnott and his colleagues reckoned it might be better to weight large U.S. companies according to their “economic footprint.” In so doing, Arnott argued, you get a benchmark yielding higher average returns than the capitalization-weighted Russell 1000 and S&P 500 indexes. More importantly, a fundamentally weighted market would be less likely to develop “bubbles,” such as the one that preceded the Tech Wreck of 2000.
Arnott and his colleagues offered some tantalizing data in their assertion. In backtesting between 1962 and 2004, the composite Research Affiliates Fundamental 1000 Index's (RAFI) annualized returns outpaced the S&P 500 by 197 basis points (1.97 percent). No small change, that.
The first ETF tracking RAFI U.S. 1000 — PowerShares' NYSE-listed RPF — emerged in December 2005. RPF amassed a shade less than $800 million in assets in its first year, putting the fund 35th in the ETFZone size ranking of 301 portfolios. between Vanguard's Small Cap ETF and Barclays Global Investors' iShares Russell 3000 Value Fund.
“Arnott's findings imply that, in aggregate, investors have been systematically overvaluing large companies relative to small companies,” says The Index Investor's senior editor Tom Coyne. “However, if one believes that financial markets are generally efficient, this shouldn't happen, as market capitalization-based weighting should provide the best estimate of future returns.”
Arnott admits to a value bias and, to a lesser extent, small-stock exposure in his RAFI benchmark. Whether that's a “tilt” can be debated, but tongues in the index world have been wagging, asking just how much of the excess return is due to these factors. One line of recent research indicates that nearly two-thirds of RAFI's excess return may, in fact, be attributable to value and small-stock exposure; only a third seems to be inherent to the indexing technique itself.
There's a definite benefit to tilting toward value and small-stock exposure in the domestic U.S. market, at least as seen through a filter devised by economists Eugene Fama and Kenneth French. The payoff — measured by excess return over large stocks — has averaged 8.4 percent per year since 1957 (see Chart 1).
Clearly, a leaning towards value- and small-stock investing could have produced outsized returns in the past, though there were times when it would have been very uncomfortable to defend such a strategy. In 14 years, or 28 percent of the 50-year history tracked in Chart 1, the net risk premium was negative.
There's considerable variance in the size of these premiums, as illustrated in Chart 2. For the past five decades, the median small-cap premium has been 2.0 percent per year while the median-value premium amounted to 7.3 percent.
“The interesting thing, however, is that these premiums are negatively correlated,” says Portfolio Solutions CEO Rick Ferri from Troy, Mich. “Correlation tests to see if the size and value premium are the same risk. The inconsistent and mostly negative correlations between size and value show that they are separate risks. “Having both small stocks and value stocks in a portfolio, or using a small value fund to kill two birds with one stone is good diversification,” he adds.
That said, portfolio runners are asking to what extent RPF mines for these premiums. “It's a known fact that RAFI U.S. 1000 has a value tilt, which explains most of its outperformance over the S&P 500,” says Michael Markov, CEO and director of research at the Markov Processes International, a performance and reporting consultancy. Backing up Markov's contention is RAFI's concentration of returns to the right and downward of the S&P 500's in the style map shown as Chart 3.
For The Index Investor's Coyne, the implication is obvious:
“While it is clear that Bob Arnott, with hindsight, has discovered a theoretically profitable anomaly,” he says, “what basis is there for assuming it will continue in the future now that it has been publicized?”
Indeed, for RAFI to continue to outperform the S&P 500, says Coyne, two assumptions have to made. “First, whoever has been making the valuation errors that gave rise to the superior historical returns will continue making them, and, second, other investors will not arbitrage away the potential excess returns by bidding up the prices of larger companies' stocks.”
Coyne thinks the odds are too long to bet on RAFI's continuing outperformance. Arnott, not surprisingly, takes issue with such criticism. “The supposed small-cap bias is a myth,” he declares. “Our average market cap is $76 billion, compared with $81 billion for the Russell 1000 and $1.1 billion for the Russell 2000 small-cap index.”
His argument on the value tilt is a bit more nuanced. “Is the cap-weighted market portfolio style-neutral, or does it have a growth tilt?” he asks. “After all, if a stock has twice the P/E ratio of another, its relative weight is doubled. Whether fundamental indexing has a value bias or cap-weighting has a growth bias, it's a fair statement that RAFI has a value bias ‘relative to’ cap-weighting. That bias will be small when the gap between growth and value is small, and large when the gap is large. So, the value bias self-adjusts to mirror the opportunity set.”
It's the “opportunity set” itself that galls some pundits, however. Burton Malkiel, for example, questions RAFI's classification as an index. Constructs like RAFI, he says, “are not ‘indexes’ in the sense that all investors can own them.” (See related story on page 94.)
To better visualize Malkiel's argument, imagine the equity market is comprised of only two stocks: the large stock has a market capitalization of $200 billion while the small stock's worth is $20 billion. The large stock would represent 91 percent of a market-cap weighted index; the small stock earns a 9 percent weighting. This $220 billion asset base represents the entire opportunity set for market participants. Thus, anyone can track the index by dropping 91 percent of his capital into the large stock and 9 percent into the small stock.
It's not so clear-cut in a fundamentally weighted universe. If a fundamental filter weights one stock at 70 percent and the other at 30 percent, the only thing that keeps the universe from blowing itself apart is the dearth of index-minded investors. If everybody took to indexing, 30 percent of the market couldn't possibly invest in the smaller stock near its current market price.
Such fine distinctions aren't keeping financial advisors from considering fundamentally weighted products for their clients, however. “I think both [cap-weighted and fundamentally based indexes] have their place in the market and portfolios,” says Mark Manning of Butler Wick & Co. “One thing you need to watch on cap-weighted funds is that they sometimes have very large positions in only a few stocks. If those are the stocks that you want to target that may be fine, but if you're buying a fund for diversification, some may not fit your needs. We use a combination of capitalization- and fundamental-weighted index funds in our managed portfolios, depending on what area of the market we're trying to target.”
Ron Surz, president of California-based consultancy PPCA, offers a road map for advisors attempting to marry fundamental- and capitalization-weighted products in a portfolio. “First I'd run a returns-based style analysis on RAFI to understand it better. Then, to integrate it into an overall asset allocation, I'd ask the optimizer to match the cap-weighted broad market index with RAFI and my other managers — ‘my style palette.’ ”
For DTB Capital CEO David Krein, making a fundamentally weighted product the centerpiece of an investment strategy means other exposures may have to be pared back as an accommodation. “If I was to use a fundamental index as the core of a portfolio,” he says, “I'd first look at its correlations to the other exposures it might crowd out to figure out the rest of my asset allocation.”
Brad Zigler formerly served as head of marketing, education and research for the Pacific Exchange and Barclays Global Investors. Zigler is a founding member of the Global Association of Risk Professionals Education Committee.