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Beyond Market Cap: How Else Can You Make an Index?

Beyond Market Cap: How Else Can You Make an Index?
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Research Affiliates' Rob Arnott and Schwab's Tony Davidow explain a new approach to constructing indexes—using company fundamentals.

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Rick Karr:
Index funds are a cornerstone of many investors’ portfolios because they offer diversification at a low cost. A controversial approach to indexing may offer those same benefits while addressing some of the risks that could come with market swings. One of my guests is the man behind the innovation, Rob Arnott, the founder of Research Affiliates. We’ll get help unpacking it from Tony Davidow, who analyzes asset allocation at Charles Schwab. 
You’re listening to the Insights & Ideas podcast brought to you by Charles Schwab. I’m Rick Karr.
Tony Davidow says there are a few reasons why index funds are attractive to individual investors. 
Tony Davidow:
They have a very difficult time deciding between selecting one stock versus another—should I own Microsoft or IBM? And there are advantages of traditional indexing: it gives you broad-based diversification, it takes a lot of the emotion out of picking which stock will be a winner and which stock will be a loser. And you see that in the extraordinary growth we’ve experienced in exchange-traded funds, which are efficient ways for the average consumer to buy these index-based strategies.
Rick Karr:
With a traditional index fund, the size of its position in a given stock is based on the market capitalization of the company. But fundamental indexing relies on certain fundamentals of the companies whose stocks are in its portfolio: earnings, cash flow and so on. Rob Arnott says the downside of building an index based on market capitalization is that it can leave you overexposed to overpriced stocks. 
Rob Arnott:
Why on earth would you want to own twice as much of a company just because it doubled in price?
And that’s what cap weighting does. So I had long felt that weighting by something other than market capitalization would make sense. Why not weight companies by their sales or their profits or their book value? We tested the idea. We found that over the course of the prior 30-odd years, it would have added 200–250 basis points per annum, which was much more than I expected to see as a result of the test.
Rick Karr:
Two full percentage points?
Rob Arnott:
Yeah. That’s astonishing.
Rick Karr:
Was there a particular fundamental metric that led to the ‘ah-ha’ moment when you realized you might be on to something?
Rob Arnott:
It was a series of ah-ha moments. It doesn’t matter which measure you use for company size, they all work about the same. And they all work about the same because they don’t add value based on choosing the right fundamentals. They add value because they sever the link between the price of a stock and its weight in the portfolio. 
Benjamin Graham used to personify the market in his writings. He would describe it as Mr. Market, a Nervous Nellie who’s constantly changing his mind about what companies are worth and which companies are going to grow and which companies are going to shrink and where the opportunities lie. And so, in personifying Mr. Market, he was tacitly saying the market’s making big active bets relative to the macroeconomy. Fundamental indexes weight companies according to their current macroeconomic footprint. And by doing that, you’re going to wind up contra-trading against the market’s most extravagant bets. 
If the market thinks a company has glowing prospects, a fundamental index will say thank you very much for these capital gains. I’m going to take the capital gains and I’m going to reweight the company back down to its economic footprint. To companies trading at deep discounts, a fundamental index will say thank you very much for the deep discounts. Yeah, I understand the company is troubled, but it’s in the price, so I’m going to go ahead and reweight it back up to the company’s economic footprint.
Rick Karr:
So, the market’s undervaluing companies with good fundamentals, then?
Rob Arnott:
On average, over time, yes. You cannot generalize and say that it’s always true, but on average, over time, companies trading at deep discounts do outperform. I mean, some of them are value traps; they’re headed to zero, and you don’t want to rebalance into those again and again and again, all the way to zero. But the value traps are sharply outnumbered most of the time by companies that are in fact cheap because they’re out of favor.
Rick Karr:
Some of the skeptics from 10 years ago have turned into believers. They’ve got strategies of their own that may look a little bit like fundamental indexing, and they’re promising some of the same results as fundamental indexing. How does the impact of fundamental indexing look from your perspective?
Rob Arnott:
To some extent, I think we opened the door for a whole array of interesting ideas to make their way into the marketplace. I think the notion of so-called smart beta gained traction after fundamental index came on the scene and demonstrated its ability to add value.
Rick Karr:
And smart beta is a rubric that would include fundamental indexing and similar strategies that share structural features with it.
Rob Arnott:
That’s exactly right. So, equal weighting, as silly as it sounds, is a smart beta approach, because it does sever the link between price and the weight in the portfolio. Everything’s equally weighted.
Rick Karr:
Tony Davidow, you’ve looked at a lot of these strategies that have been inspired by fundamental indexing. Are they all created equal?
Tony Davidow:
Rick, I think it’s very challenging for individual investors and advisors to distinguish between all of these strategies available in the marketplace, and a lot of people who either call them smart beta or strategic beta strategies assume that they’re all created equally. We’ve done a lot of research on it, and we’ve spoken to a number of individual clients and institutional clients over the last couple of years trying to provide some guidance on how to distinguish between these strategies. As Rob points out, we’re very fond of fundamental index strategies because of the rigor that Rob and his team did before they brought these strategies to the market. Where we are concerned about some of these ‘me-too strategies’ where maybe they haven’t had the rigor behind them, and we wonder, will they all perform the same way going forward? So, I think the topic certainly warrants some careful consideration.
As people think about these strategies, they shouldn’t assume all smart beta strategies are smart. And it really warrants spending a little bit more time to understand what is the underlying methodology, what’s the length and the rigor that went into the track record. These strategies actually vary quite a bit over time.
Rick Karr:
Tony, you have said to me before that when there’s volatility in the market, like we’ve been seeing recently, it’s good to have a steady hand on the tiller. Is this one of those times?
Tony Davidow:
I think, Rick, as we’ve talked about, we believe there’s a role for active management, and active management where somebody does have their hands on the steering wheel and they’re trying to make decisions. And there’s a lot of research that’s been done, research that we’ve conducted here and others in the industry, that shows the difficulty of active managers persistently outperforming a passive benchmark.
But we’d argue maybe the discussion needs to be turned around. We think a lot of the value of an active manager is the ability to play defense when times get tough, as they are now.
Rick Karr:
Gentlemen, this has been a great conversation. I hope you can both come back and talk about this a little bit more sometime. Rob Arnott, chairman and founder of Research Affiliates, thank you so much for joining us.
Rob Arnott:
It’s a privilege. I’ve really enjoyed this conversation.
Rick Karr:
And Tony Davidow of Charles Schwab, thank you.
Tony Davidow:
Thanks for having us, Rick.
Rick Karr:
Tony Davidow analyzes asset allocation strategies at Charles Schwab. 
And that is it for this edition of the Insights & Ideas podcast, brought to you by Charles Schwab. You can find us on iTunes or go to Insights.Schwab.com. Our producer is Matthew Nelson. I’m Rick Karr. Thank you for listening.

Important Disclosures

Past performance does not guarantee future results. Investment value will fluctuate, and is subject to loss of principal.  

The information provided and individual securities are for informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. 

All corporate names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security. Supporting documentation for any claims or statistical information is available upon request.

Index ownership—Russell Fundamental Index Series” is a joint trademark of Frank Russell Company Investments (“Russell”) and Research Affiliates LLC (“RA”) and is used by the fund under license. “Research Affiliates” and “Fundamental Index” are trademarks of RA. Subject to RA’s intellectual property rights in certain content, Russell is the owner of all copyrights related to the Russell Fundamental Index Series. Russell is the owner of the trademarks and copyrights related to the Russell Indexes.

Contra-trading, in the context of this episode, refers to rebalancing by selling companies that have outperformed and buying companies that have underperformed.

Research Affiliates and Rob Arnott are not affiliated with Charles Schwab & Co., Inc.

Opinions expressed are those of the speaker and their associated firms.  

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

For more information regarding the studies and research cited, please visit ResearchAffiliates.com or Schwab.com.

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