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Differentiating This Research Affiliates Index From the Pack

Michael Rawson, CFA

Mike Rawson: Hi. I’m Mike Rawson with Morningstar. I’m here today talking about fundamental indexing. Joining me today is Brent Leadbetter, who is a product specialist with Research Affiliates.

Brent, thanks for joining me.

Brent Leadbetter: Thanks very much for having me, Mike.

Rawson: Brent, Research Affiliates, of course, is headed by Rob Arnott, one of the innovators really in fundamental indexing. But I think one thing that I sometimes fail to really appreciate is that fundamental indexing, the way you’ve constructed it, is different than the traditional value-versus-growth style buckets. At Morningstar, we’ve been talking about style investing for quite some time. But how is, let’s say, your large-cap fundamental index different than a Russell 1000 Value?

Leadbetter: We’re using nonprice measures of size in order to both select and weight constituents for indexes. So that means instead of, as you see in a typical cap-weighted index, where your weight is simply share price times number of shares outstanding, we’re using fundamental metrics like sales, cash flow, dividends, or book value in order to both select constituents for indexes, as well as to weight those constituents within the indexes.

Rawson: I think that’s an important distinction. Typically in a traditional value index the weighting is still being driven by the market capitalization. One of our favorite funds that we like here at Morningstar is Vanguard Dividend Appreciation. It selects stocks based on the growth in the dividends the companies have paid over time, but at the end of the day it’s weighting them really close to a market-cap weighting. But that’s going to give you a different set of exposures at the end of the day than the fundamental index. Is that correct?

Leadbetter: That’s correct. You’re going to have a much different experience over time if you are weighting by market cap as opposed to weighting by fundamental metrics of size.

Rawson: Great. Another question I have for you: you’re using these fundamental measures of size: cash flow, maybe dividends, maybe sales, or book value might be going into your model. At the end of the day, is this giving me a traditional Fama-French value exposure? Can I expect, "It’s going to give me a tilt toward value; it's going to give me tilt to small cap," is that what I should expect to see?

Leadbetter: You do get tilts to both value and small cap. What’s unique about a fundamental index strategy is that those tilts change over time, and they actually change in a very dramatic and pronounced manner. The reason being that if you’re weighing by metrics other than price and you’re rebalancing back to those metrics on a regular basis, what you’re essentially doing is you’re undoing the price strip that’s occurred since your past rebalance. You’re trading against the market, and what we’ll see is that the value tilt or the size tilt, or even the relative country or sector exposure in a fundamental index when compared with a cap-weighted index, what we see is that the over and underweights are essentially a mirror image of the market’s willingness to overpay for whatever risk factor you’re looking at, whether it’s value exposure, size, country, or sector exposure.

Rawson: I think that’s quite interesting and unique, because what you’re essentially saying is that your exposure to value is not static. It’s dynamic. It kind of depends upon the market’s valuation. I listened to a presentation [of yours] and a gentleman had a question asking whether this is the same as what Dimensional Fund Advisors is giving him. I thought it was an interesting response. It’s actually quite different what the DFA is doing, but then there is another aspect, which I think might be similar, and this wasn’t brought up at the presentation. So I’m going to throw you this curveball here. DFA talks a lot about their trading, how they add value through trading and being patient traders. They’re not pushing the price up. That almost sounded a little bit to me like what you might be doing in your rebalance, maybe not as systematic, or maybe the time frequency is different. But with your rebalance, you’re essentially buying the stocks that have maybe a little bit underperformed over the past quarter and maybe selling the stocks which have outperformed. Is that true? Do you see a similarity there?

Leadbetter: I do see a similarity there. We don’t actually trade the portfolios. Our partners actually go out and trade the portfolios through mutual fund and ETF products. We’re just licensing the index. But you’re completely correct, in that when you’re rebalancing, you’re offering liquidity to the market. You’re not taking liquidity away. We’re adding weights to companies that have gone down in price and we’re trimming the weights of companies that have appreciated in price. We’re offering liquidity to the market instead of taking it out. So it’s very similar to the trading strategy you described.

Rawson: Great. Well, Brent, your boss, Rob Arnott, is actually going to be here in Chicago for the ETF Invest Conference in early October, so that’s coming up. He’ll be presenting on Friday. I look forward to hearing him. He’s presented before. Of course, he is always a great speaker. Brent, thanks for your time today.

Leadbetter: Mike, thanks very much for having me.

Rawson: For Morningstar, I’m Mike Rawson.