"Fundamental Weighting" and Indexing

Joseph Nocera reviews the bidding:

Passions Run High on Indexing: the Financial Analysts Journal... letters the magazine published in its March/April issue. André Perold, a finance professor at Harvard Business School, had written an article in a previous issue criticizing a new kind of financial product called fundamentally weighted indexes, which have been devised in large part by a man named Robert D. Arnott. Mr. Arnott is the chairman of Research Affiliates, a six-year-old company that markets and licenses such funds — and he’s also the former editor of The Financial Analysts Journal. “André Perold’s article in the November/December 2007 issue entitled ‘Fundamentally Flawed Indexing’ might have been better titled, ‘A Fundamentally Flawed Critique,’ ” steamed Mr. Arnott, in a letter jointly written with the Nobel laureate, Harry Markowitz, who is one of his consultants.

Mr. Perold quickly shot back (“This characterization is completely inaccurate.”), as did several other participants in the debate. It reminded me of the good old days at The New York Review of Books, when authors would spend issues on end cagily insulting each other in the letters page. There is nothing quite like an old-fashioned academic cat fight....

At its core, the fight is about whether fundamentally weighted indexes — which, unlike traditional index funds, don’t rely on market capitalization to “weight” a stock in an index — are superior to old-fashioned index funds, which allow investors to invest in such broad market indexes as the Standard & Poor’s 500 or the Russell 2000.

Obviously, Mr. Arnott thinks the answer is a resounding yes; so convinced is he that he is onto something big that he’s trying to patent his methodology. Mr. Schwab, Mr. Markowitz and Jeremy Siegel, the Wharton economist who serves as a consultant and spokesman for Mr. Arnott’s chief competitor, Wisdom Tree Investments, are all in this camp.... Critics include Mr. Bogle — who helped create the original index fund — Mr. Malkiel, Mr. Perold (who is a Vanguard director), and Clifford Asness, the co-founder of AQR, a big quantitative hedge fund.... I came away thinking they’ve both got a point....

A traditional index fund is a mirror of the market. The Vanguard 500 Index Fund, for instance, replicates the stocks in the Standard & Poor’s 500... larger market capitalizations have a larger weighting in the index than stocks with smaller market caps. Investors who use index funds (and everyone should!) do so in part because their costs are so low... but also because they have learned the essential futility of trying to beat the market....

But that doesn’t mean the stock market is completely efficient.... On any given day, some stocks are overvalued while others are undervalued.... Thus, back in 1999, when Cisco Systems had, absurdly, the largest market capitalization in the world, it also had the biggest weighting in the Vanguard 500 Index Fund.... Indeed, it was the Internet bubble that really gave impetus to fundamental indexing. “I remember George Keane, the founder of the Commonfund, saying to me that there has to be a better way to index,” Mr. Arnott told me the other day. “We have people investing tens of billions of dollars in index funds and they are getting drawn into bubbles.” Mr. Arnott continued: “It was very clear what was wrong with the index was that the weight was linked to the price. If the price was wrong the weight was wrong.”...

When you talk to Mr. Arnott — as well as Mr. Siegel, speaking for Wisdom Tree — about why fundamental indexing seems to beat the market, at least on an historical basis, they offer several theories. One is that, by using a company’s fundamental measures to weight the stocks, their indexes are eliminating all the “noise” surrounding individual stocks that can cause them to become over or under valued.

Secondly... they are, in effect, tilting their weighting toward value stocks and away from growth stocks....

The real point of contention, however — and the reason this matters to investors — is that Mr. Arnott and Mr. Siegel make it sound as if their new indexing strategy is so far superior to traditional indexing that investors should abandon the latter for the former.... “It is not indexing,” insists Mr. Bogle. “It is a form of asset allocation, or active management strategy. It is being oversold as something it is not.”... According to Mr. Bogle, Mr. Arnott and the Wisdom Tree folks are trying to do what all active managers do: beat the market. And sometimes they will, and sometimes they won’t. But they are not going to match the market because their funds are not, ultimately, trying to replicate the market the way a cap-weighted index fund does...

The argument for indexing is that the average investor will receive the average return. Divide investors into four groups: (i) passive investors, (ii) active investors who know more than the average active investor, (iii) active investors who know less than the average active investor but think they know more, and (iv) active investors who know less than the average active investor and think they know less. Group (i) should index: they will receive the average return on average--and indexing is the way to do this with the least risk. Group m(iv) should index as well: if they don't index, they are the fools in the market--and they know enough to know that they are the fools. Group (ii) profit from their knowledge, inasmuch as group (iii) and those of (iv) who don't act on their knowledge of their own ignorance are their lawful prey--but everybody who thinks that he or she is in group (ii) should ponder hard whether he or she is in fact in group (iii) instead.

"Fundamental indexing" is a form of (ii): those who engage in it are active investors, and their informational edge--the thing they know that the average active investor doesn't--is that there are enough noise traders of group (iii) out there in the market that book or earnings or other fundamental weighting factors provide an easy way to take on the role of the house in the casino that is the stock market.

This is, I think, true--until there comes a day when there are enough investors following fundamental-indexation strategies that they become part of the least-informed half of active investors.

Comments

[Padraig]

This is, I think, true--until there comes a day when there are enough investors following fundamental-indexation strategies that they become part of the least-informed half of active investors.

And thus we see dialectics at work in the processes of capital. The new technology gives some economic unit a systemic advantage over its competition, until the new technology spreads around the system, creating a new equilibrium. The seeds of Fundamental Indexing's destruction as a way of beating the market are contained within itself. Whee!

[Matt]

Well, Brad, what you are stating, in other terms, is that our economic models are not stable. They do not have equilibrium points.

[John Emerson]

Every new financial thingamajig gives windfall profits for the first person who figures out how it works. After that, only God knows what happens.

[Bernard Yomtov]

is it reasonable to be suspicious of the methods used to develop these "fundamental" weightings? You can always find weightings that produce above average returns on historical data. That's not enough.

[Maynard Handley]

" "Fundamental indexing" is a form of (ii):"

Oh Brad, the things people can do with language.
This whole article is predicated on the claim
(a) "On any given day, some stocks are overvalued while others are undervalued" and
(b) that the people running these funds know something about this.

The very fact that we're using language that pretends that the "value" of a stock is some sort of intrinsic property that always exists and is constant, if we could only build an alethiometer to measure it, shows that there is some seriously empty thinking going on here.
If the people running these funds do in fact know which stocks (on average) are going to rise in price over some time period along with which others are going to fall (note the non-misleading language I use), then OF COURSE what they are doing is asset allocation. Bogle is 100% right to be pissed off that they are not calling themselves what they are.

I also don't understand why they are afraid to call themselves asset allocation. This is not a bad label. Heck, anyone who is currently overweighed in Euro assets relative to dollars right now is engaged in asset allocation. Anyone who abandoned housing a year ago on the grounds that "this cannot continue" is asset allocation.

But, of course, when you asset allocate, like when you follow any active strategy, canny investors are going to ask for some proof that what you're doing actually works. Run your algorithm against US historic data, and presumably you get good data from the training set. Now run it against Euro data and what happens?
It's not good enough that you are right occasionally --- are you right often enough and at the right times to earn your commission?
Starting off by fundamentally misportraying what you are doing, and then lashing out at people who dare to call you on it does not inspire confidence in the answer.

[jerry]

Once you've determined the fundamental value of every public company, it should be easy to slice off those in a tranche that are overvalued and short them, and slice those off that are undervalued and long them in a tranche.

Also, it seems trivial and uncontroversial to determine the market weighting of a company, but it seems very difficult and controversial to determine the fundamental value of every company. And in determining the market value, do we use mark to market, how do we determine the value of off balance sheet transactions, and how do we value nonsense like amortized goodwill?

I think it's a great idea.

[Bram Cohen]

Determining how much of a company to buy based on fundamentals? I seem to recall an old-fashioned technique which did that ... having some trouble remembering the term ... maybe it was 'value investing'?

Seriously, if a fund were equally weighted with a coherent formula for how to do rebalancing, or balanced between stocks and bonds with an equivalent risk profile (that is, high yield) and had a coherent formula for rebalancing, then I'd say it has some claim to being in the same spirit as index funds but with a very slight edge, and solid historical data to back up the claim. This thing is just a mutual fund with some fancy marketing.

[jim]

Arnott's criticism of conventional (market cap-based) indexing is, of course, correct. When a stock is booming, then index fund managers are obliged to purchase more of it, which makes it boom even more, until it stops booming, at which point they are obliged to sell some of it which pushes its price further down (so they need to sell more . . .). Index funds increase volatility, not necessarily to their holders' advantage.

A line I remember from a trader: "when you find a trick that works, you ride it until it stops working, then you look for another trick."

A trick stops working when too many people employ it. Maybe index funds (and ETFs) have become too popular and are now a trick that's stopped working. Arnott's looking for another trick.

[Robert Waldmann]

As quoted Bogle's distinction between "active management" and "indexing" seems circular to me. He defines the traditional index as "the market" and concludes that it is "the market." I think that one can define inactive management with two criteria -- diversification and well inactivity. Both approaches give highly diversified portfolios and I see no advantages there.

Fundamental indexing, however, is active trading as shares must be bought and sold to keep proportions, by value, in the index in line with earnings (or whatever). There are transactions costs so high that they would make fundamental indexing a rubes game. Bogle should (and probably has) noted how much fundamental index funds trade. Definitely more than index funds.

One can calculate how inefficient markets have to be for a fundamental index fund to outperform an index fund. My guess is not very, but, as you note not perfectly efficient.

Like you, right now, I would go for a fundamental index fund over an index fund.

[Cal]

One of my friends works for Research Affiliates, what he has shown me is that overtime, Arnott's model does not match the highest highs and it does not match the lowest lows. Further, when it is down, the downward performance is narrower and shallower. But I don't have the minimum $ requirement to invest with them. They also have really really competitive fees. He doesn't call it an index fund and he doesn't call it asset allocation. He just says they make money.

[James Wimberley]

"The argument for indexing is that the average investor will receive the average return." Surely that can't be quite true. A fund that is tracking relative capitalisation is always shifting its allocation into stocks that have just gone up, and out of ones that have just gone down. The lag creates a small discount to the ideal instantaneous track of the market. A tracker fund can trade more frequently to reduce this gap, but pushes up its trading costs.

Look at it another way. Tracking say dividends can be made as mechanical as tracking capitalisation. You need to construct an index (Wimberley's 499) of companies with the greatest flow of dividends. If the stock value converges in the long run on a discounted flow of dividends, my index will not diverge fundamentally from the S & P 500. My investors will reap the average flow of dividends. How is this active investing? What's the logical priority of capitalisation over dividends?

[robertdfeinman]

The thing is everyone thinks they are above average, just like in Lake Woebegon. Drivers all think they are better than average and savvy investors do as well. That this is untrue is shown by the simple fact that mutual fund results (which are all run by smart, active investors) fall on a bell curve. In any year half do worse than average. So where is the expertise that we are paying these advisers for?

A well-balanced index fund, with low expenses is a reasonable choice for us, mere mortals. If high flyers want to gamble and call it investing, who are we to stand in their way? Any scheme can appear to work for a while. Do you remember the ones tied to trading on certain days of the week or times of year?

[meno]

"Divide investors into four groups: (i) passive investors, (ii) active investors who know more than the average active investor, (iii) active investors who know less than the average active investor but think they know more, and (iv) active investors who know less than the average active investor and think they know less."

THIS IS THE STATISTICS POLICE.

WE HAVE THE PLACE SURROUNDED.

YOU ARE CONFLATING MEDIAN ("the average active investor") WITH MEAN ("an active investor who achieves the mean return"). MOST ACTIVE INVESTORS ARE "BELOW AVERAGE" BY THAT MEASURE, WHICH DOES NOT MAKE GOOD SENSE.

SURRENDER THE POINT AND COME OUT WITH YOUR HANDS UP.

meno

[meno]

"When a stock is booming, then index fund managers are obliged to purchase more of it,"

No.

When a stock is booming the shares the index fund owns boom sjust as much. So as the stock goes from 0.1% to 0.2% of the market, it also goes from 0.1% to 0.2% of the fund.

That's the beauty of passive investment funds: there's very little buying and selling (ie very low transaction/management costs). And hence Bogle's criticisms of the "fundamental index" funds.

[Sunlight]

Of course fundamental indexing makes more sense than price indexing. As one who has been a markets professional for nearly 25 years, I remember how the rise of Microsoft, Cisco, Dell, Ebay and their ilk forced indexers to buy more of the Internet bubble stocks as other people bid them up, even when the indexers knew that indices would eventually sour when the internet/TMT bubble broke. Of course they were in for a hit when things turned around.

The fundamental index pushes investors to buy more of companies as they become more profitable. This would force one to take profits on bubble companies and use the proceeds to buy companies with low P/Es. The strategy would also keep one out of money losing concerns (like banks and investment banks after accounting for writeoffs). Sounds like a decent, workable, longterm plan. Does it include the ability to anticipate explosive future earnings growth that first rate investors have? No. But then, most of us do NOT have access to that kind of talent; a well constructed index allows one to win over time without being possessed of genius.

[a]

On indexing vs. active management: it depends. i think you need to look at risk-adjusted returns. Some investments that have lower long-term returns than indexes and higher fees may have better risk-adjusted returns, or may be better for liquidity in emergencies (personal or systemic). You also need to look at an investor's specific situation and his (or her) goals (eg, sell illiquid assets at death or preserve illiquid assets for next generation).

If possible, I tend to believe in product allocation \ assortment: index funds - fundamental and price, actively managed funds, insurance products (risk management - annuities, permanent insurance, etc), and a handful of individual stocks. You might do some on your own and some through a trusted advisor. It also depends on a person's risk preference, goals (self-emplyoment vs. corporte vs public sector), other assets (eg, illiquid equity in house in Berkeley, CA), etc.

You do not want to overdue it and have too many accounts and products (some concentration is okay, especially as you gain experience and knowledge to make better decisions), but you do not want to underdo it either.

You might not get rich from diversification and risk-management (as opposed to plunking everything on one individual stock that turns out to boom), but you are less likely to be broke or in a bind.

All this for free. Open source