Fundamental index concept gets institutional investors’ attention

The fundamental index concept is generating interest as an alternative to traditional equity indexing among institutional investors.

• The Washington State Investment Board in June issued an RFP for fundamental index managers.

• The California Public Employees' Retirement System and San Joaquin County (Calif.) Employees' Retirement System are looking into the concept.

• PIMCO Funds launched in June two mutual funds, based on the fundamental index that have since grown to $317 million.

• PowerShares Capital Management LLC registered with the Securities and Exchange Commission in August to launch an exchange-traded fund based on the new index.

Robert D. Arnott, chairman of Research Affiliates LLC, Pasadena, Calif., created the concept and the Research Affiliates fundamental index (Pensions & investments, Sept. 20, 2004).

Instead of using traditional market capitalization to weight index components, fundamental indexation selects, ranks and weights equities using fundamental measures of company size, including book equity value, sales and cash flow, according to a Research Affiliates statement. "Fundamental indexes offer investors the same features as traditional passive capitalization-weighted indexes, including low turnover costs, broad diversification, vast capacity and transparent, rules-based selection," the statement said.

The Research Affiliates indexes, both domestic and global, have outperformed traditional indexes in the short and long term by about two percentage points a year, based on back testing, said Mr. Arnott.

Research Affiliates in August formed separate ventures with FTSE Group, London, and Nomura Asset Management Co., Tokyo, for equity products based on the fundamental index.

FTSE has a three-year agreement to license the RAFI for the United States and international financial markets for investment and benchmarking products, said Mr. Arnott. It will calculate, publish and rebalance the index under methodology developed with Research Affiliates.

Nomura has a three-year exclusive agreement to market investment products based on the RAFI in Japan to pension funds, money managers and other investors in the country, Mr. Arnott said. Nomura would have to license the index from FTSE for any marketing outside Japan.

The $6 billion South Dakota Retirement System, Sioux Falls, became the first institutional investor to invest in the fundamental index when early this year it put $100 million in an enhanced RAFI index fund, managed by Research Affiliates. "I've recognized this is a very smart guy who has built a substantial reputation of research and integrity in the investment industry," Steve Myers, state investment officer, who retired in January, said at the time (P&I, Jan. 10).

Steven A. Schoenfeld, chief investment strategist-global quantitative management, Northern Trust Global Investments, New York, a major index manager, viewed the rush to the new index with reservations.

"It's surprising fiduciaries are rushing to invest in this index when there are so many questions," he said. "The index is being commercialized at a lightning-fast pace, yet the index itself does not exist," he added, explaining "the index doesn't exist from a neutral, third-party calculating firm yet," which is what the FTSE agreement would provide.

"Rob Arnott is well respected," said Mr. Schoenfeld. But "he is promoting the index before the idea has been vetted by the industry. No one has been able to see the what the weight of the constituents are."

"A number of clients have asked us to do an analysis of this index, but we can't assess it without the data," said Mr. Schoenfeld, an expert on indexing methodologies.

"This is not an index," he added. "It is a quasi-active index ... or enhanced strategy calculated as an index."

Mr. Arnott said "I'm puzzled at the suggestion the methodology is not transparent because it is very simple." He said the methodology was in an article published earlier this year in the Financial Analysts Journal.

"We don't actually print the formula, but it's pretty straightforward," he said. "We don't publish rules," which he called nuances. "The basic principles are straightforward."

Mr. Arnott said individual stock component weightings are given only to licensees. "We don't want to encourage people without a license, because that is the way inventors get compensated," he said.

"We are seeking a patent because it is so simple. Simple ideas are the ideas that need protection."

"The program is off to a fast start," Mr. Arnott added. "It's on a lot of people's radar screens. I'd be surprised if it isn't a couple billion dollars by the end of the year" in RAFI index fund assets, "and $5 billion by the end of next year."

"I think the whole industry is watching it," said Amy Schioldager, managing director, head of U.S. equity indexing products at BGI in San Francisco.

"We are curious about it. But we are wondering where it will fit into a plan sponsor's allocation, or if it will fit in. ... It's appropriate to look at whether there are other weighting methods aside from market-cap weighting." Mr. Arnott "is challenging efficient market theory," she said.

But Ms. Schioldager echoed Mr. Schoenfeld in questioning whether RAFI truly is an index. "I don't view this as being an index product, but an active product," she said. "He's built an index around it, but the index is active in its creation.

The $61.3 billion Washington State Investment Board, Olympia, is searching for one or more managers to run a U.S. equity fundamental metrics index, based on a company's fundamentals, including total income. Board officials, who oversee $61.3 billion in pension assets, didn't set the portfolio size. The RFP doesn't mention RAFI.

The $196.7 billion CalPERS, Sacramento, is examining fundamental indexing, said Brad Pacheco, spokesman; there is no further information on when officials might decided whether to use such an index.

The San Joaquin County system, Stockton, Calif., is also considering fundamental indexing, said Robert Palmer, retirement administrator. Mr. Arnott is scheduled to meet with the board of the $1.7 billion system in October to discuss the concept.

PowerShares, Wheaton, Ill., hopes to launch an ETF using the FTSE RAFI US 1000 index by the end of the year once it receives SEC approval. It is "an alternative to traditional market-capitalization weighting," said Benjamin Fulton, PowerShares senior vice president-product development.

PowerShares officials are negotiating with the New York Stock Exchange, American Stock Exchange and Nasdaq on where to trade the new RAFI ETF, Mr. Fulton said.

At Pacific Investment Management Co., Newport Beach, Calif., both its RAFI funds used futures, rather than individual stocks, to replicated the index, said Sabrina Callin, PIMCO executive vice president-product manager.

Both use the same RAFI 1000 strategy, said Ms. Callin; the difference in the two funds is the duration of the underlying fixed-income portfolio.

For the period June 30 through Aug. 31, the PIMCO Fundamental IndexPLUS Fund, which has $45.9 million in assets, underperformed the S&P 500 stock index by 0.06 percentage points, while the PIMCO Fundamental IndexPLUS Fund Total Return, which has $271.9 million in assets, outperformed the S&P 500 by 0.06 percentage points. Both returns are before fees.