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ETF Special Report

George Keane, the founder of investment consultancy Commonfund, once challenged Robert Arnott to come up with a better method of indexing. And depending on whom you ask, Arnott may have succeeded. As the story goes, Arnott, the chairman of Pasadena, Calif.-based quant shop Research Affiliates, had been following Keane's toils overseeing the New York Common Retirement Fund. And in 1999, Keane proposed

George Keane, the founder of investment consultancy Commonfund, once challenged Robert Arnott to come up with a better method of indexing. And depending on whom you ask, Arnott may have succeeded. As the story goes, Arnott, the chairman of Pasadena, Calif.-based quant shop Research Affiliates, had been following Keane's toils overseeing the New York Common Retirement Fund. And in 1999, Keane proposed shifting half of the pension fund's then-$30 billion in assets from the growth heavy S&P 500 to the Russell 1000 value index. But given the prevailing school of thought on indexing and the S&P's rosy returns, Keane's proposal was met with staunch opposition. Against his better judgment, Keane maintained his position in the S&P 500 — and, of course, the pension fund paid the price.

But the challenge had been set: How to create a better index? How to get market returns — or better — but without having to ride the manic mood swings of investors? In late 2002, Arnott met with Keane and former TIAA-CREF CIO Martin Leibowitz to discuss ways to improve upon the traditional market-capitalization method of indexing. Arnott started off with a sales-weighted index and he found that, in backtesting, one “improved” index averaged 200 basis points of annual excess return more than the passive index. Arnott eventually tested others, using balance-sheet value metrics, such as dividends and cash flow. Arnott's ongoing discussions with people like Keane, Leibowitz and Peter Bernstein, the economist and author, eventually led him to write a research paper, along with co-contributors Jason Hsu and Phillip Moore, for the Journal of Financial Analysts entitled, “Fundamental Indexation.” Published in March 2005, it would quickly circulate through the investment community and become the cornerstone for several start-up ETF companies. Out of that research effort the first fundamentally weighted index, the FTSE RAFI US 1000, was born.

Growing In Popularity

Fundamental indexes, which weight companies in the portfolios by their financials rather than their stock price, are cropping up and winning retail cash flows. ETF purveyors such as PowerShares, WisdomTree (see page 34) and Claymore have all introduced a lineup of ETFs based on indexes built around fundamental factors. And Rydex has introduced a lineup of equal-weight ETFs. Together, they took in $7.2 billion out of the $42 billion in net new money last year and $1.1 billion out of $1.7 billion already this year, according to Financial Research Corp. The shift away from traditional market cap-weighted indexes among these newer players has enabled them to carve out a niche for themselves among the giants of the industry, namely Barclays Global Investors, State Street Global Advisors and The Vanguard Group. These nouveau indexers boast that their way of weighting allows for better performance over the long run — that's right, they claim to have found the strategies that consistently beat the market.

“In a less-than-efficient market, we know that some stocks will be priced above or below their true fair value,” Arnott says. “Those priced above true value will have an erroneously higher capitalization and, therefore, index weighting. In this manner, cap-weighted indexes systematically overweight overpriced securities and underweight underpriced securities. Fundamental indexes avoid this return drag and, as a result, produce returns in excess of 2 percent annually over the 45 years we tested.” (Arnott's RAFI 1000 indexes beat the S&P by 2.1 percent per year dating back to 1962).

This recent fundamentalist insurgency has bolstered the use of ETFs among retail financial advisors, who, until recently, had largely ignored passive investments for their clients. But ETFs' low cost, liquidity, tax advantages and ability to gain access to certain market segments is alluring to advisors and investors alike — especially those who have been burned by active managers charging higher fees for subpar performance.

While traditional ETFs have served the institutional crowd well for more than a decade, fundamental ETFs are now making significant strides in the retail market as well, where fee-based business and open architecture are taking hold. Charles Schwab is launching its own lineup of fundamental index funds this month.

The investment philosophy appears sound and is backed by some of the most astute investment minds. Still, FAs may want to look under the hood and see if these shiny new toys live up to their billing. While there are many new kinds of ETFs, by and large, what fundamental ETF investors are really getting is a portfolio of small-cap value stocks, which, are performing well in the current climate, but may not continue their hot streak. Arnott disputes the small-cap bias. “The criticism is a clean miss,” he says. “On average, it's a very slight bias and certainly not enough to explain 2 percent annual excess returns.”

Another fundamentalist claim — that backtesting has shown these strategies to work — draws heavy criticism from efficient marketers, such as Princeton University Professor Burton Malkiel (see his defense of cap-weighted, passive indexing on page 86), and John Bogle, the legendary curmudgeon and founder of Vanguard. In his new book, The Little Book of Common Sense Investing, Bogle calls backtesting “data mining,” run by a new breed of “financial entrepreneurs” and “promoters” who “sincerely feel (if with a heavy dollop of self-interest) that they can create indexes that will beat the market. Interesting!” He argues that “the past is not prologue” in investing and when a strategy works, it attracts others and the advantage tends to get exploited out of the market — so that it no longer works. Which is why Bogle says it's best just to buy a broad index and go home. “Never think you know more than the market. Nobody does.” He also says, “It is no accident that these new index funds are being introduced only after their strategies have seen their best days.” In short, as usual, investors are chasing the hot dot, he says.

Bogle does acknowledge that in a traditional cap-weighted index half of the stocks may be undervalued and half overvalued. But, Bogle asks, “Who really knows which half is which? And the new fundamental indexers unabashedly answer, ‘We do.’ They actually claim to know which is which.”

Just Act Rational

Still, fundamental indexing is a notable innovation, and certainly has a place in the world. But you have to know how to use it. Regard fundamental indexes as an alternative that gives advisors and investors more choice when looking for low-cost, low-turnover investments. They behave differently than traditional market-cap weighted indices, but it's too soon to tell whether it will outperform over the long run or when growth takes over, as it inevitably will.

Dan Culloton, senior research analyst at Morningstar, says the strategy is far from revolutionary. “They're just taking value investing strategies and codifying them in the form of an index. What's new here is the method of delivery rather than the underlying strategy.” Another analyst warns reps to make sure they understand what's behind the packaging. “I caution advisors to know what they're getting,” says Paul Mazzilli, director of ETF research at Morgan Stanley. “If somebody wants a core holding value approach with decent dividend yields — which are tax efficient these days — it's attractive and in some cases less volatile. If you want beta and growth, that's not part of the equation.”

Arnott is credited with being the first person to build an index based on fundamentals. But the concept of investing in smaller companies that have a low P/E, of course, dates back to Columbia University professors Benjamin Graham and David Dodd, the gods of value investing. Other influences include Dartmouth finance professor Kenneth French and University of Chicago economics professor Eugene Fama, who founded Dimensional Fund Advisors (DFA) in 1981. Their Three Factor Model questioned the prevailing theories on stock investing, such as William Sharpe's capital asset pricing model, or CAPM. DFA contends that tilting the portfolio towards small-cap and value leads to better performance over time. And history supports that notion with value outperforming growth by 5.1 percent annually since 1927, according to Fama/French.

While a number of money managers have experimented with fundamentally weighted portfolios over the years, none of them have been wildly successful. Robert Jones at Goldman Sachs Asset Management is said to be the first to reweight the S&P based on adjusted operating earnings. He managed the firm's equity portfolios on this basis and beat the S&P 500 by 1 percentage per year between 1990 and 1996. But the funds didn't attract much in assets.

The idea is to avoid single-stock or single-sector risk inherent in cap-weighted, passive indexes. At the height of the bubble in 2000, Cisco represented 4 percent of the S&P 500. Meanwhile, by Arnott's measures, Cisco represented only 0.02 percent of the economy. This means that the S&P 500 stock-selection committee assigned Cisco a weight in the index 200 times larger than the company's scale in the economy, making it a more important part of the future economy than five gigantic companies combined. Historically, company and industry market caps have been highly correlated with their commensurate roles in the American economy.

But that relationship weakened in the late 1990's as companies with relatively small revenue streams, became “worth” far more than boring ole blue chips, like the big five oil companies. In 1999, AOL's market value of $200 billion placed it among the 10 largest companies in the United States. Yet, in the prior year, AOL's sales ranked only 415th in the country, and its profits ranked 311th. If AOL's market value ranking was in line with its sales or profits rankings, its market cap would have been closer to $4.5 billion.

Similarly, in April 1999, after a 48-fold price increase in less than two years, online bookseller had a market value over $30 billion. This was almost 10 times the combined market value of its two greatest “bricks and mortar” competitors, Barnes & Noble and Borders, each operating more than 1,000 bookstores worldwide. Ironically, Amazon had never, up to that point, made a profit; in fact, it had losses that year of over $600 million. In this way, the S&P 500 became a poor proxy of the U.S. economy and had morphed into a growth index, skewed by overvalued New Economy companies. The tech sector swelled and, at its height, represented 28 percent of the index. So when technology tanked, so did the S&P 500.

Fundamental indexing, on the other hand, says a true measure of a company's impact on the index are its underlying business fundamentals — and not its share price, which is prone to be distorted by investor enthusiasm (or pessimism). Had the S&P 500 been weighted according to earnings, dividends, revenue or book value, investors would have been insulated from the crash. For example, the high P/E, low-revenue technology sector would not have comprised 28 percent of a broad market index. This is what perturbed Wall Street followers like Wharton's Jeremy Siegel, who had been a proponent of passive indexes. “I had become disenchanted with cap-weighted indexes during the tech bubble,” he says. (He now is an advisor to fundamental indexer WisdomTree.)

ETF purveyors who have adopted Arnott's investment strategy say it's an improvement on an old, broken-down model. “Indexing is being redefined,” says Bruce Bond, CEO of PowerShares. “The weightings are different but the securities are generally the same except you're screening out for the really poor companies and getting the best apples in the barrel.” (PowerShares bases its indices off four fundamental factors including book value, cash flow, sales and dividends). Tim Meyer, Rydex ETF business manager, agrees. “There needs to be some movement away from cap weighting.”

ETF Distribution by Channel
Channel AUM %
Institutional $263,697 61.86%
Wholesale (advisor sold) 100,698 23.62
Bank 30,303 7.11
Direct 26,840 6.30
Unknown 4,773 1.12
Source: Financial Research Corp.
U.S. ETF Asset Growth
Year # ETF Offerings AUM
2002 109 $101,985
2003 116 150,767
2004 152 227,354
2005 206 301,889
2006 335 418,496
2007 YTD 359 426,312
Source: Financial Research Corp.
Top ETF Players by Market Share
Firm Assets %
Barclays Global Investors Funds $253,938 59.57%
State Street Global Advisors 99,626 23.37
BNY Hamilton 26,840 6.30
Vanguard Group 24,142 5.66
Powershares Capital 9,759 2.29
Rydex Funds 3,833 0.90
WisdomTree 1,970 0.52
Victoria Bay Asset Management 1,259 0.46
DB Commodity Services 948 0.30
First Trust Advisors 596 0.14
Van Eck Corp. 589 0.22
Claymore Advisors 483 0.14
Fidelity Distributors 116 0.11
Source: Financial Research Corp.
Top ETF Asset Gatherers by Net Flows
2006 2007 YTD
Barclays Global Investors Funds 44,514 1,134
Vanguard Group 8,075 1.369
Powershares Capital 4,784 512
State Street Global Advisors 1,732 (1,939)
Rydex Funds 1,245 58
WisdomTree 998 428
Victoria Bay Asset Management 705 541
DB Commodity Services 614 164
Van Eck Corp. 371 152
Claymore Advisors 194 166
Fidelity Distributors 6 (29)
First Trust Advisors (122) 20
BNY Hamilton (4,644) (995)
Source: Financial Research Corp.
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