| Fundamental Indexation 101 |
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| 30/07/2006 | |
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Robert Arnott, Chairman of Pasadena-based Research Affiliates LLC, answers this week's 101 on fundamental indexation Fundamental Indexation 101 1-What is fundamental indexation and how does it compare with a conventional index? The primary method for weighting each security in a conventional portfolio is to utilize its capitalization, essentially the enterprise's market price. This approach has many advantages – diversification, low turnover, market participation and modest expenses. However, capitalization weighted indices suffer a major flaw, a return "drag" if you will. In a less than efficient market, we know that some stocks (and occasionally many) will be priced above or below their true fair value. Those that are priced above true value will have an erroneously higher capitalization and, therefore, index weighting. In this way, capitalization weighted indices systematically overweight overpriced securities and underweight underpriced securities. Fundamental indexation was developed to address this structural return drag. By weighting securities on fundamental metrics of company size, we are able to randomize these weighting errors and eliminate the linkage between portfolio weight and any over- or under-valuation. These size metrics are closer to how "Main Street" gauges the economic footprint of a company: · Income or Cash Flow · Sales or Revenues · Book Value · Dividends Over the forty-five year evaluation period, the Research Affiliates Fundamental Index™ produced excess returns of 2% with less volatility than similar cap-weighted indices in large company US equities. Furthermore, the Fundamental Index™ advantage extended to smaller company portfolios, international equities and even within economic sectors (technology, health care, consumer, etc.) of the market. 2-How can an investor get exposure to equities through Fundamental Indexes™? The Fundamental Index™ isn't just theory - it is being utilized by institutional and individual equity investors today in a variety of geographical and company size mandates. Like other major indices, a global index provider provides licenses and data feeds to investment managers or plan sponsors to run Fundamental Index™ portfolios. Likewise, individual investors can access certain exchange traded funds or mutual funds linked to Fundamental Indexes™. Globally, we estimate $3.5 billion is already invested in Fundamental Index™-linked portfolios based upon our methodology, which we believe to be substantial given that our original work was published only 15 months ago. 3-What kind of institutional investor can / should include this type of strategy in its portfolio? Fundamental indexation is appropriate for investors looking to boost returns over the next five to ten years in what we believe to be a paltry single digit period for conventional stocks and bonds. These can include pension plans with relatively high long-term return on asset assumptions or endowments with spending policies in excess of 4-5%. With this mindset, these institutional investors have sought "alpha" or excess returns above the market. This alpha-searching has taken many forms such as loosening constraints, finding better managers, and exploring new structures like portable alpha and hedge funds. Fundamental indexation is based on a different premise – achieve the same excess returns just as effectively by eliminating negative alpha as by finding and employing sources of positive alpha. By reducing the return drag of cap-weighted indices, excess returns are achieved in a more efficient and cost effective manner. Interestingly, our research confirmed that Fundamental Indexes™ tend to add more value in weak capital markets, exactly the type of environment we envision over the next decade. |
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