PASADENA, Calif. — Robert Arnott this week will unveil a new U.S. stock index that employs a "Main Street" approach based on fundamental factors, rejecting the traditional "Wall Street" capitalization-weighting method that dominates the industry.
At the core of Mr. Arnott's assault on traditional indexation is a belief that market-cap-weighted indexes are inefficient. While this notion is accepted widely in academia, it upsets the conventional wisdom that cap-weighted indexes are optimal portfolios under the capital asset-pricing model.
The key insight: the cap-weighted index "is inherently trend-following and tends to overweight the most overvalued stocks and underweight the ones that are the most undervalued," explained Mr. Arnott, chairman of Research Affiliates LLC, Pasadena.
That is, cap-weighted indexes tend to have their biggest exposures to stocks with the greatest momentum. The tech-stock bubble of the late 1990s illustrated to many that valuations of stocks can be skewed.
Mr. Arnott created a 1,000-stock index based on six fundamental factors, such as sales, dividends and employment. The index, which weights those factors equally, outperformed the Standard & Poor's 500 index by 1.65 percentage points per year over the 42-year period ended Dec. 31, Mr. Arnott wrote in a paper that has been submitted to the Financial Analysis Journal. (Mr. Arnott edits the FAJ, but the paper is being reviewed by independent referees.)