As the value rally ebbs, will Arnott's theories hold water?
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
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."
If that conversation had happened, it's easy to imagine that S&P would have said, "You know, let's create an index that's weighted on company size." And if they had done that, the whole notion of capitalization weighting would have been nothing but a quaint, academically interesting concept. It would never have been embraced because it would have shown the underperformance that we see in our historical tests. People would have looked at it and said, "Sure, this is academically interesting, but why on earth do I want to use this?"
KK: During the past decade, we've seen growth stocks-tech stocks in particular-grow to become a large share of the S&P 500 and then greatly contribute to the decline of the index. If you were to pull out that time period, what does your research show?
RA: The two best years for Fundamental Index were, of course, the aftermath of the bubble as tech stocks were getting crushed, 2000 and 2001. The two worst years were the late stages of the bubble when tech stocks were soaring, 1998 and '99. Take out the two best and two worst years and what's the average return over that span? Two percentage points better than the S&P.
KK: Sounds like I'm talking to a value manager.
RA: (Laughter) Fundamental Index is inherently a value-tilted concept relative to the cap-weighted markets. Now, the reason for that is actually very simple. With cap weighting, you take companies that are at twice the market multiple and you give them double their economic weight. Companies at half the market multiple, you give them half their economic weight. So cap weighting has a growth tilt relative to the economy. Fundamental Index is utterly neutral relative to the economy and, therefore, will always have a value tilt relative to the cap-weighted market.
KK: If I were to look at some of your indexes today versus what they would have looked like, say, seven years ago, what would be some of the key differences?
RA: Very modest differences. The one that's changed is cap weighting. Cap weighting has gone from paying monumental premiums for growth to paying modest premiums for growth; it has gone from enormous industry concentrations based on perceived future growth, based on the new paradigm story, to having modest concentrations by industry.
KK: Considering that we've been in a unique environment for smaller-cap stocks and value-oriented strategies, would you say that some of the returns that you've seen in the past 10 years are not immediately repeatable and that maybe expected returns will be a little bit lower, even if they're better than traditional S&P 500-type strategies?
RA: To be sure, coming off what in retrospect was the biggest bubble in U.S. capital markets' history, the value added that we can expect from Fundamental Index will be much less than we've seen this decade. I haven't checked the numbers recently, but for this decade to date, I think the value added has averaged over 6% per year compounded. Now, if people buy into the Fundamental Index concept based on an expectation that they're going to add 6%, they're making a terrible mistake.
We are operating with the tailwind of a market in which value is sharply outperforming. If you look over the course of a growth/value cycle--where growth outperforms and then value outperforms--first, cap weighting gets the tailwind from growth; then, Fundamental Index gets the tailwind from value. Net net, we find Fundamental Index adds 2% to 2.5% a year over spans of time in which growth and value have the same returns. So I think adding that kind of incremental return is a sensible expectation, but adding the 6% we've seen this decade, not plausible.
KK: It's reasonable to point out, however, that the expenses of some of the funds that the strategy's available through are higher than those of a traditional index fund. Aren't you giving up some of the advantage that you're pointing to?
RA: I think Jack Bogle and I are on the same side with the angels on that. That is to say, we're both big fans of low expense ratios. Relative to active management, the expense ratios of the Fundamental Index products are drastically lower.
KK: So you view your competition as active management in that sense, instead of traditional indexes?
KK: Because the debate between traditional indexing and fundamental indexing has been portrayed as the old guard of indexing versus the new guard.
RA: Right. But it's also worth noting that the S&P 500 Index fund that Vanguard pioneered wasn't priced at seven basis points back in the early days. In the early days of indexing, the pricing tended to be a quarter to half percent.
KK: You've been able to gather assets pretty quickly, as well.
RA: Oh, yeah. And what we will see is that as this idea gains traction, the fees will come down. Part of it's a scale issue. If you're running $100 million, it's more expensive than if you're running $100 billion as a percentage of assets. But which is the bargain? Something that costs 60 basis points and adds 200 to 300, or something that costs 10 basis points and adds zero?
KK: Some critics have questioned the timing of when you launched these indexes, which was after value stocks had rebounded. Why didn't you do it when the strategy would have added the most value, which was right around the time of the bubble as opposed to its aftermath?
RA: I couldn't control when the idea occurred to me. In fact, the trigger in large measure was the aftermath of the bubble. The catalyst that got me focused on this occurred two years after the bubble burst when it came to my attention that the average stock on the New York Stock Exchange was up over 20%. The indexes were down over 20%. You had this 4,000-basis-point gap between the performance of the indexes and of the average stock, so the indexes weren't tracking the behavior of the average company. And that's what got us started on this. The fact that Fundamental Index would have added more value had it been embraced at the peek of the bubble-well, it wouldn't have been embraced at the peak of the bubble because the prior couple of years were the two worst years ever for Fundamental Index.
KK: When you're out in the marketplace now, how do you talk about using some of these strategies within a portfolio?
RA: I think there's a couple of ways to proceed, and the answer to that really varies depending on the customer. To me, Fundamental Index is a much more sensible core portfolio. It is neutral relative to the composition of the economy and contra trades against whatever are the most extreme bets, up or down, in cap weighting. I see it as a very elegant, powerful core portfolio.
Those who say, "Well, relative to the market, it's a value-tilted portfolio" heck, in that context think of it as the best value alternative for the value side of your portfolio. It becomes even more powerful in international applications where you get country rebalancing. So I see this as an idea that naturally serves as a core. Should people put all of their core money in it? I would, but.
KK: Do you?
RA: I have all of my core equity holdings, which are limited because I have a cautious view on equities, but all of my core equity holdings are in this because if I'm right this adds a ton of value in most down markets. If I'm wrong, it keeps pace in most up markets. What's better than that?
But what we find is that part of the issue of how to use Fundamental Index depends on who you are. Fundamental Index adds value seven out of 10 years historically. Suppose you're an investment advisor, and you put all of your client's core equity money into it at the start of one of those off years. Dangerous. So for most advisors, I think putting one fourth or one third of core equities into Fundamental Index is a wonderful first step to get clients comfortable and familiar with the idea.
KK: Is there a danger, as with other investing strategies, that when something becomes popular, the advantages begin disappearing?
RA: This is an idea that has enormous power in terms of being scalable. We've penciled it out at $1 trillion. At $1 trillion--with the U.S. top 1,000--we would have 5% of the total market. We would have over 20% of the float of only 20 companies, most of them at the bottom of the list comprising less than 1% of the portfolio. So we'd have to start paying attention to float issues at somewhere around a $1 trillion AUM. This is a very scalable idea. It's extremely low turnover.
KK: Though not as low turnover as a typical index strategy.
RA: Barely higher if you do it our way. Our way smoothes the financial measures of company size over time because there is volatility in sales and profits, and by doing that, the turnover's 10%, against 6% for cap weighting. It's a very slight difference. And either way, it's drastically lower than the 100% that's fairly typical in active management.
So the idea is hugely scalable. If $1 trillion flowed into the idea, what would happen? Growth and value would be more similarly priced, the alpha of Fundamental Index from that point forward would be diminished, but the alpha during that transition would be increased, so that there is an early adopter advantage that's tough to quantify, but it's there.
KK: One of the things that strikes me as I look at the market today is that some of the best values are large-cap companies. In my mind, that argues in favor of traditional indexes.
RA: Think of it this way. Fundamental Index takes you from market weighting, with whatever biases and preferences are in the market, back to economic weighting. So you're contra trading against wherever the market has its most extreme bets. Now, for large versus small, most of the time, the market pays a premium for large companies and discounts small companies. Fundamental Index in that environment says, "Well, wait a minute. These companies are bigger than they're given credit for. Let's weight them according to their economic scale." So you have a small-cap tilt.
Today, it's the opposite. The market's paying a premium for small caps, so Fundamental Index says, "Well, wait a minute. These companies aren't that big. Let's reweight them to their economic scale," which creates a large-cap tilt. It's a myth that this idea has a structural small-cap tilt. It only has a small-cap tilt when the market's pricing small caps at a discount.
We are asked, "Aren't you going to be disappointed if big caps rebound and outperform small caps?" No. We'll be pleased, because we now have a large-cap tilt.
KK: Speaking about the broader market, let's shift gears a little bit and talk about your view of the markets right now. You indicated earlier that you're not optimistic on equities.
RA: I have a cautious view on equities. The simple fact is most of our clients and most clients of financial advisors will have most of their money in stocks. So the question is to what extent that you really have to have stocks in the portfolio. If you're an FA and you say, "Get out of stocks," and you're wrong, that's a career-ending decision. Given that equities will remain a major part of the portfolio, what equity structures do best in a weak market? That's the beauty of Fundamental Index in that context.
But I think equities have some vulnerabilities. The vulnerabilities for equities today relate largely to the fact that we have earnings representing a 40-year peak as a percentage of GDP at a time when wages are an all-time minimum share of GDP. I think the notion that you can take these peak earnings and extrapolate historical earnings growth is just naïve. Even if it continues for another year or so, watch out for the political backlash. It'll be huge.
Now, earnings do revert to the mean over time. Historically, they tend to grow 1% to 2% faster than CPI over a very long span. Recently, they've done far better than that, and there are folks who extrapolate that growth and say, "Well, they've grown faster and they'll continue to grow faster." I don't think that's plausible. If you go back historically and ask what's the precedent for 8% earnings growth--the consensus expectation off of peak earnings-there is none in the entire history.
KK: But some would argue that a lot of those earnings are coming from outside the United States. Doesn't that change the picture somewhat?
RA: Absolutely correct. But it's naïve to assume that U.S. companies can earn a growing share of non-U.S.-sourced profits relative to the domestic providers.
KK: They certainly seem to be doing okay, even if they're not taking a majority share.
RA: But how sustainable is that as the domestic competition in these overseas markets get up to speed on how to compete effectively?
What we find historically is that when earnings are 50% to 60% above their 10-year average, as they are today, the subsequent 10-year growth in earnings averages a little less than inflation, a little negative in real terms, which would mean very low single-digit growth, 1% or 2% in notional terms over the next 10 years.
The market is expecting much faster growth, so the biggest risk we've got right now in the markets is earnings disappointments. They are in my view about as close to inevitable as anything ever gets in the markets.
KK: When you make this comment, it's obviously a broad market comment.
RA: Yes, it is.
KK: If you go deeper, are there pockets where these problems are more prevalent than others, or do you think it's a broader problem?
RA: I think it's a broad problem. I'd be hesitant to say specific sectors or industries are more or less vulnerable. Of course, they are, but I think the more powerful issue is that this is a valuation problem for the stock market. People are pointing to P/E ratios based on next year's expectations that are in line with the 50-year average P/E ratio. Well, that's true. But that's if those earnings materialize, and that's if the earnings continue to grow from that foundation, both of which I think are suspect.
KK: Where are you putting your money?
RA: The markets that I like are emerging markets' debt in the local currency. There's a very nice premium yield associated with the natural fears that emerging markets' currencies will falter. Well, consider the fact that most of these economies have fiscal surpluses, current account surpluses, no off-balance sheet budget items the way the U.S. does, and that if the U.S. were not the dominant economy in the world, it would be getting referred to the IMF for counseling.
So, what's the prospect for emerging markets' currencies? I think it's to go up, not down. I think you get a currency play that it is likely to be profitable and a yield play that's likely to be profitable. But I like the short end of the curve a little better than the long end, because the yield pick up is still almost as good.
If you want a non-dollar play to diversify away from the U.S. dollar, there's nothing better out there in my view than emerging markets' debt denominated in the local emerging markets' currencies.
Another thing I like is floating rate notes, floating income. It's below-investment-grade, short-maturity paper. Now, the beauty of this asset category is that the yield pick up is three to four times the historical default rate. The risk, of course, is that the default rate picks up in a recession, but the subprime contagion hammered this sector, creating a wonderful buying opportunity because these assets are, for the most part, utterly unaffected by and unrelated to subprime. They're related to the economic health of the individual companies. That represents a wonderful way to pick up additional yield without a lot of downside and without the kind of default risk that afflicts longer maturity high-yield debt.
Third is TIPs. We've got inflation out there, which is a lot more than the government likes to acknowledge. A lot of it is fueled by the secular bull market in commodity prices, which I think has quite a ways to run. A lot of it is fueled by costs of goods and services that don't compose the core inflation metrics.
Now, to be sure, if we have a recession--and I think that's better than 50/50 odds--inflation will not rear its ugly head in the coming year in any material way. But no one believes inflation is gone for good. And when inflation does come back, whether it's next year or the year after or the year after that, how many people think that they'll see it coming? Most people don't. Having a protective anchor in your portfolio invested in assets that are priced to benefit from renewed inflation, such as TIPs, represents a very powerful alternative.
KK: What do you think a good expected return is for equities and some of the fixed-income asset classes you've mentioned?
RA: I'd say 5% to 7% for many of these asset categories. I don't think the equity risk premium is all that brilliant right now. I think stocks are priced to give us 5% to 7% on a 20-year horizon. So one of the implications in terms of direct action items for your readers is encourage clients to ramp up their savings and to ramp down the spending out of the portfolio. For individuals, it would be much the same. What's the number one best place to put your investment dollars? Pay down credit-card debt.
Beyond that, a nice defensive posture makes sense in today's markets where people are paying much too much for risk, as if the risk doesn't have two sides to it.