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By Greg Brown | 06-24-2010 12:55 PM

Arnott on the Case for Fundamental Indexing

Research Affiliates' Rob Arnott illustrates the points of the fundamental indexing strategy and answers criticisms that say it's simply a value-tilted approach.

Greg Brown: The final question was about fundamental indexing, and I just wanted you to touch on that and why you think it's a better method over traditional indexing methodologies?

Robert Arnott: Think about it this way: a core principle of successful investing is you want to own more of what you think will perform better.

If a stock doubles in price with cap-weighted indexes, which are the dominant form of indexes in the marketplace, you suddenly own twice as much of it. Tacitly that means that with cap-weighting, you're assuming that a stock's prospects are better after it's soared than before it has soared.

Intuitively, that makes no sense. Intuitively, we rebalance on an asset class level if one asset class soars, we take some profits and move it into other asset classes. Why don't we do that within stocks?

Now, if you're going to rebalance, if you're going to use that stock doubling as a basis to take some profits and redeploy that money into cheaper investments, what anchor do you use for rebalancing? Equal weighting works. That's one reason equal weighting has had historically higher returns. It's a clumsy way to do it. It's an expensive way to do it; trading costs are large, turnover is large.

What about just using the company's size? How big is the company? Right now, you have Apple priced at 85% of the market capitalization of ExxonMobil. It's the second-largest market capitalization company on the planet. Great products, yes; great prospects, absolutely; great prospects as an investment, not necessarily. You're already pre-paying for a continuation of this spectacular success for years into the future. You are pre-paying for that. If it doesn't happen, you've overpaid. Is Apple going to be the second-largest source of profits in the decades ahead of any company on the planet? That strikes me as a stretch.

Fundamental index would say, Apple Computer, that's half a percent of the U.S. economy. Cap-weighting says, Apple computer that's 3% of the market cap of the economy. So, fundamental index says, here is my anchor, I'm going to contra trade against this.

It doesn't mean that Apple is going down. It doesn't mean that Apple is inherently overpriced. It just means that you're using an economically meaningful anchor to contra trade against all of the market speculations – some of which are right, and some of which are not right. And to the extent that you can contra trade against those you add value.

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