My 2-year-old whoops with laughter as her bubble machine cranks out a seemingly endless supply of soap bubbles into the air.
Investors, however, find bubbles to be much more troublesome affairs — especially when they burst.
To fundamental indexers such as Robert D. Arnott, chairman of Research Affiliates LLC, capitalization-weighted indexes essentially are bubble machines: they lure investors into inefficient market baskets that are prone to collapse.
In their new book “The Fundamental Index,” Mr. Arnott and co-authors Jason C. Hsu and John M. West point to $500 billion in wealth destruction from one stock — Cisco Systems Inc. — in the 30 months following the bursting of the tech-stock bubble in March 2000. Of that half-trillion-dollar loss, one-fifth was absorbed by index fund investors.
While the authors credit market-cap index funds with superior performance to most active managers after fees, they argue that traditional index funds are built on a faulty foundation.
The biggest flaw is they're based on the “efficient market hypothesis,” which equates the price of a security with its fair value. While EMH was almost universally embraced by the academic community for many years, virtually all investors and now many academics realize that securities are not priced correctly every minute of every day.
In a foreword to the book, Nobel Memorial Prize Laureate Harry Markowitz writes that fundamental indexation is “at odds with classical finance theory, which says that we can't beat the cap-weighted portfolio.” But that theory is built on “doubtful” assumptions in the Capital Asset Pricing Model, he explains.
By construction, cap-weighted indexes place the greatest weight on the most expensive stocks and reduce weightings in the cheapest stocks, thus rewarding growth stocks with high price-to-earnings ratios, Mr. Arnott says. Because the majority of the cap-weighted portfolio is invested in overpriced stocks that eventually will revert to mean, the traditional index fund is subject to a performance drag, he says.
By switching to a “fundamental” index that weights stocks based on economic factors such as cash flow and book value, the portfolio will be, on average, half in overvalued stocks and half in undervalued stocks. The return drag disappears, the authors argue.
The proof is in the pudding. The U.S. large-cap fundamental index has beat comparable cap-weighted indexes by more than 200 basis points per year over a 46-year span ended Dec. 31, based on back-tested and real-time results. In developed markets, an international version produces an annualized 260 basis points in added value over traditional indexes over the 24-year period ended Dec. 31, again based largely on back-tested results. The figures are yet higher for small companies and for emerging markets stocks. Even in 2007 — a year that favored growth stocks — fundamental indexes performed better than market-cap indexes in most markets, Mr. Arnott says.
Yet fundamental indexation continues to stir controversy among academics and investors. The chief criticism: fundamental indexation is a pure value play. The authors' answer: while the index has a value tilt, that explains only part of its outperformance. They also deny the main index has a significant small-cap bias. They also rebut attacks that they've engaged in data mining and that the strategy has high costs.
What's more, they dismiss critics who question whether fundamental indexation is an index or an active strategy. “What you call it isn't that big an issue as far as I'm concerned,” Mr. Arnott said in an interview.
Whatever you call it, his anti-bubble strategy is likely to keep winning adherents.
