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Rob Arnott and Kunal Kapoor

As the value rally ebbs, will Arnott's theories hold water?

Morningstar Advisor, 01/01/2008

Active managers have argued for ages about the right way to beat the market, while much of the indexing world has been content to simply match the market. Not that that's a lowly goal, what with the vast majority of active managers failing to simply keep up with their bogys.

But the indexing world has been somewhat topsy-turvy lately. The preponderance of ETFs is forcing more differentiation among index providers, and a growing chorus of investors now argues that traditional market-cap-weighted indexes are faulty. From DFA to WisdomTree, these purveyors of indexing strategies are all laying claim to "the right way to index."

But perhaps nobody has garnered as much attention as Robert Arnott of Research Affiliates. The former editor of Financial Analysts Journal prefers to weight companies according to factors such as their sales, book values, cash flows, and dividends, while ignoring market cap. The strategy, on display at offerings such as PIMCO Fundamental IndexPlus Total Return Inst PXTIX and PowerShares FTSE RAFI US 1000 PRF, has quickly caught the attention of investors who were burned by the performance of traditional market-weighted indexes during the last bear market.

Others, however, have been less welcoming. Vanguard founder John Bogle and Vanguard index chief Gus Sauter have both lambasted the strategy, equating it to another case of performance chasing. After all, Arnott's methodology leads to portfolios that have thus far favored small-cap and value stocks at precisely the time that such stocks have enjoyed a strong run of outperformance.

So, is Arnott just another performance chaser or is there more to his methodology than meets the eye? To find out, Kunal Kapoor, president and chief investment officer of Morningstar Investment Services, caught up with him Oct. 30 in Las Vegas at the 2007 Schwab Impact conference and put him to the test, challenging some of the core assumptions that underlie his beliefs about index construction. This conversation has been edited for clarity and length.

Kunal Kapoor: The issue that's on the top of a lot of people's minds is your research in fundamental indexing. It's been very successful for you.

Rob Arnott: Well, Fundamental Index is definitely a topic that has gotten immense play, and it has resonated in the marketplace The biggest shock in doing all of this research is that it wasn't done decades ago. Imagine, if you will, that back in 1956 when Standard & Poor's was getting set to launch the S&P 500 if there'd been somebody at the table saying: "Wait a minute. The companies in this index, based on its market capitalization, are going to wind up automatically, systematically, and irrevocably overweighting any companies that turn out to be overweight and underweighting any companies that turn out to be underweight. Why don't we just weight companies by how big they are? Do it on sales. Do it on profits. Do it on book value."

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