5. Fundamental Indexing
Rob Arnott of Research Affiliates (RA) does not believe that markets are wholly efficient or that markets are entirely rational, and he says that his conclusions are supported by strong empirical evidence and the growing body of work in behavioral finance.
He asks a question about the validity of cap-weighted methodology: “Cap-weighting claims that the market price is accurate, but if market price does not equal fair market value, how big is the difference?” Arnott says that analysts try to analyze the next quarter sales and earnings and are often off the mark. If they cannot accurately judge the next quarter’s earnings, how can they judge what earnings will be two or three years out? The fair market value of a company should reflect its earnings potential decades into the future. If market participants agree that price differs from fair value, and cap-weighted indexes are based on market value, mathematically cap weighting structurally over-weights the overvalued and structurally under-weights the undervalued.
Arnott concludes that in a cap-weighted index, most of the money is in over-weighted companies because the index is over-weighting these companies, and this creates a built-in performance drag, or what RA terms “negative alpha.” Arnott’s research is dedicated to breaking the link between portfolio weight and stock price, which frees a portfolio from owning more of stocks when they are expensive and owning less when they are cheap.
RA says that freeing a portfolio from this potential performance drag by building a portfolio according to non-price weighted measures—in RA’s case, by the fundamental size of a company—enhances performance significantly. RA created its “Fundamental Index” (RAFI) in 2004. RA says the reason its alternative to cap-weighting indexing has blossomed is the simplicity of its concept and the success RAFI has had in its performance over cap-weighted indexes.
For instance, RA has constructed indexes that are replicated by mutual funds and ETFs, such as the PowerShares FTSE RAFI US 1500 Small/Mid-cap ETF (symbol PRFZ) and the PowerShares FTSE RAFI US 1000 ETF (symbol PRF). PRF tracks the performance of the 1,000 largest U.S. companies, based on four measures of firm size: book value, cash flow, sales, and dividends. The key point is that the RAFI strategy measures and weights the portfolio based on the largest companies, not the largest stocks according to market capitalization. The RAFI fundamentally weighted portfolio is rebalanced and reconstituted annually. PRFZ tracks the performance of 1,500 mid-cap and small-cap U.S. equities, based on the same four measures of firm size.
According to Morningstar, during the five years ending in December 31, 2010, PRF, which was the first RAFI fundamental ETF offering, had an annual return of 4.3 percent. The companies in the index are all large-cap companies, which is similar to the S&P 500 Index. PRF performed about 2 percent better in this time frame than the S&P 500 Index. The PowerShares FTSE RAFI Developed Markets ex-US ETF (symbol PXF), which fits into the foreign large-cap value category, for the three-year period ended December 30, 2010 and returned a negative 5.8 percent. This was a better performance than the MSCI EAFE index, which returned a negative 7.0 percent.
On a three-year basis, PRFZ also outperformed the S&P 500 Index. The more appropriate benchmark for PRFZ is Russell 2000, which is a small-cap index. According to RA, PRFZ beat the Russell 2000 index since its September 2006 launch date.
Fundamental indexing and other alternative weighting methods do not guarantee profits or over-performance of cap-weighted indexes. There are times when the stock market is more of a momentum, growth-led market, and at that time, cap weighting might outpace other weighting. This is true in stock market bubbles. RA thinks this is because cap-weighted indexes keep riding the high-flying groups, such as the biotech stocks of the early 1990s or the dot-com Internet stocks of the late 1990s, to large portfolio weightings. Studying more than 200 years of market experience gives RA comfort that the next bubble ends the same way as the previous bubbles and the fundamental index investors benefit.
Comparing Equal-Weighted Indexes and Cap-Weighted Indexes
One of the first ETFs offered was the S&P 500 Equal Weight ETF, brought out by Rydex (symbol RSP). Each of the 500 names in RSP has a 0.2 weighting, and the selection committee rebalances the portfolio quarterly.
According to analysis by RA, in the years 2001–2005, the equal-weighted index was up 51 percent. The S&P 500 Index was up only 1 percent. It’s worth looking at why there was such a big difference. In 2001, the S&P 500 was heavily weighted in companies that had the highest price/earnings multiple in history. In January 1995, the S&P 500 Index was invested in only about 11 percent technology. In March 2000, this sector weighting had grown to about 34 percent. Having that much in technology created built-in risk. But technology was on a roll, and many traders and investors kept piling in.
The S&P 500 Index was heavily concentrated in the technology sector because of the stocks’ high multiples, which some indexers say is the nature of cap weighting. At the same time, the average index stock in the index was more moderately priced, and the average stock subsequently performed adequately.
RA found that, surprisingly, the bull market did not end for most companies until April 2002. The bull market that started in the early 1980s continued for two years after the tech stock bubble burst, and then the average stock joined in the decline and the entire market entered a bear phase beginning in April 2002. Six months later, the average stock started its recovery.
The cap-weighted indexes produced poorer results than the average stock in the 2001–2005 period. The market in that period favored both value stocks and small-cap stocks. The S&P 500 Equal Weighted Index had a value tilt, and value stocks drove its good returns. In the previous five-year period, 1996–2000, which was a period that favored growth stocks, the S&P 500 Index outperformed the S&P 500 Equal Weighted Index. Even so, the S&P 500 Index, with its heavy tech concentration, did not beat the equal-weighted performance by much, returning 132 percent versus 112 percent for the equal-weighted portfolio, or 2 percent a year.
Portfolio Underperformance Problems
Big companies that are respected, growing, and are known worldwide are expected to grow for a long time. RA says that if market price equals a company’s fair value, plus or minus an error, the error being uncertainties relating to the unknowable future, then it is expected that some companies would have a higher market capitalization than they deserve. Those companies are overvalued.
You might look at the top ten highest-capitalized stocks today and wonder what might happen to those companies in the future. In 20 years or so, investors might look back and see that some of the top ten stocks were good companies and deserved a top ranking. What about the other companies on that list? There is a good chance that people will shake their heads and wonder what the market was thinking, that the market assigned a top ranking to some companies that were in retrospect not that good and did not deserve a high market-cap weighting. The companies with an undeserved multiple place a drag—or negative alpha—on index performance.
Investors cannot know which companies these are until after the fact. RA stresses that fundamental indexing doesn’t try to pick the winning and losing stocks. RAFI doesn’t make active stock bets, but simply owns a group of companies that fit its weighting methodology.
RA found that on a rolling ten-year basis, over the last 80 years, three out of ten of the top ten stocks on the market-cap rosters outperformed the average stock, and seven out of ten underperformed the average stock. An index that picks the wrong stocks seven out of ten times can cost you real money. RA considered the margin of the underperforming stocks of the top ten stocks, and it was substantial: the underperforming stocks were down an average of 26 percent to 30 percent relative to the market over the subsequent ten years.
These are only ten stocks, and because they are so few, one might wonder if their underperformances made a real difference to their index performances. It is true that they are only ten stocks, but RA found that much of the time, these stocks comprised about 25 percent of the weighting in an index. If a cap-weighted index has a fourth of its money in stocks that underperform by 26 percent or more, that index has a built-in structural performance drag.
Ways to Enhance Performance
RA studied cap weighting to see how it can be improved. Cap weighting, in its view, has a substantial growth bias. Growth companies usually have higher multiples, which means that investors think that prospects for those companies are good and are willing to pay more for each dollar of current earnings. A growth bias by itself does not hurt investors, and the companies often do grow and their high multiples are sometimes justified.
If the market is doing its job, determining worth and adjusting stock prices so that stocks sell according to their true values, those companies will be priced at just high enough multiples to justify their future growth. The returns on growth stocks will then be the same as the returns for the other stocks in the market. However, the only way an investor can earn an excess return is for these stocks to deliver better-than-expected growth.
RA says its studies have shown that cap-weighted indexes often make it certain that investors have peak exposure to a stock, a sector, or a country just before a bubble bursts. Cap-weighted index investors wind up pursuing the latest fads with high expectations and shun the stocks that are most out of favor.
One way to correct this structural problem is to weight an index equally and ignore market price, valuation multiples, and similar factors. Another way is to use the size of the fundamental factors of the companies in index calculations, which is what RA does. In its opinion, the RAFI strategies offer better liquidity, scalability, and representation of the stock market and general economy.
A company size can be measured in many ways. It can be evaluated on the amount of sales, book value, dividends, or in other ways. Weighting in these ways affects an index’s returns. RA studies show that if weighting is done on any of these valuations, materially higher rates of return can be achieved on a long-term basis. This leads to the question of which measure or measures to use for valuation purposes.
RA studies suggest that no single measure leads to an ideal and complete picture of a company or group of companies. Just like a footprint in the sand has multiple measurements, such as length, width, and depth, the footprint that a company has in an economy has different aspects to measure. Using multiple measures, a composite, aggregate scale of a company in an economy can be determined.
For example, suppose that IBM comprises 4 percent of the U.S. economy as measured by dividends, and 3 percent by sales and by profits, and 2 percent by book value. An argument can be made about whether IBM is 2, 3, or 4 percent of the economy, leading to an agreement that these numbers could be averaged. The agreement is that IBM represents 3 percent of the economy and has a 3 percent weighting in the RAFI fundamental index.
The weighting doesn’t have to be exactly right. All that matters is the weight be independent from over- or under-valuation, which is caused by linking weighting to the price of the stock, allowing the market price to determine the company weightings that go into the index. For RAFI, this weight is the anchor for rebalancing, and for trading against the market’s constantly changing opinion about the future growth prospects for a company.
By using the fundamental type of approach, which selects, ranks, and weights companies by a company’s fundamental measures, there is no linkage between portfolio weight and over- and under-valuation. RA thinks that this eliminates cap-weighting’s negative alpha.
Fundamental and Capitalization Weighting in U.S. Stock Sector Weighting
The purpose of the following graphics is to show what happens in a U.S. stock cap-weighted index and a U.S. stock fundamentally weighted index over time. Look at Figure 5-1.
Figure 5-1. What happens with cap-weighted stocks. The index data published herein is simulated, unmanaged, and cannot be invested in directly. (Source: Research Affiliates)
RA says that Figure 5-1 shows what happens when stocks become over-valued, especially in a bubble period or an antibubble period. Each band in Figure 5-1 is a sector weighting. The most notable sector—weight bubble and burst—is the technology sector. Over time, technology had about a 10 percent weighting in the capitalization- weighted index. The technology bubble in the late 1990s saw that weight increase significantly to about 30 percent.
RA says that when an index has the most weight in the stocks that are the most over-valued simply because the prices went up, the sectors in a cap-weighted index will have peak weightings when the stocks in that sector have peak valuations. RA thinks that this is the flaw in cap weighting, that there are errors in price. Stocks move beyond fair value, in both directions, but when they become caught in a bubble, there will be more over-valued stocks in a cap-weighted index. RA says that when reversion to the mean occurs, stocks move back toward fair value, and a cap-weighted index suffers more because there is more weight in the expensive stocks. With cap-weighting, an investor rides the sectors up and then rides them down.
The RAFI Fundamentally-Weighted sector weighting, as shown in Figure 5-2, shows a different pattern than cap weighting.
Figure 5-2. What happens with fundamentally weighted stocks. The index data published herein is simulated, unmanaged, and cannot be invested in directly. (Source: Research Affiliates)
The sector bands in Figure 5-2 are smoother and steadier over many decades compared to the sector bands in Figure 5-1. The technology sector is about 10 to 15 percent over time, and it grows slightly, which is to be expected because technology companies grow, are dynamic, and technology has become a larger factor in the U.S. economy. But investors were too excited about technology in the late 1990s and suffered a big return drag when that sector corrected. RA annually rebalances its fundamentally weighted portfolio and didn’t have an overweighting in technology stocks.
Cap-weighting indexes do not rebalance, which RA says is an important difference between the two indexes. Based on research, RA says that it has shown that it has added approximately 2 percent in the U.S. index over a 60-year period, and two-thirds of that 2 percent comes from what it calls “dynamic contra-trading,” which is essentially rebalancing. That is an important part because it allows fundamental indexing to capture pricing errors. If RA didn’t rebalance, it says, its index would ride stocks up and down, just like cap-weighting does.
Fundamental indexing rebalances back to its “economic” anchor. RA uses fundamental economic measures because it believes it is representative of the companies in the index in relation to the U.S. economy. Equal weighting can be used, or a single factor such as dividends, or a number of other factors, but RA finds the only negative outlier is cap weighting, which uses stock prices to decide weights.
In Figure 5-2, note that the financial sector weighting has increased over time. As the percentage of profits, sales, dividends, and the book value of that sector in the U.S. economy has grown, the sector weighting in the overall economy has increased. RA says that it is not critical what the overall weight of a sector is. Over time, the fundamental index has an underweight in technology and healthcare because those companies usually have more of a “potential profit” factor. Biotech companies, for example, are “cash burn” companies and don’t pay dividends because they reinvest in their growth and research, or they hope for a blockbuster drug. Tech companies often search for a new technology. RA says that when you look at the actual fundamental sizes of those businesses, they are smaller than the market expects them to develop into.
The market is sometimes right and sometimes wrong in its expectations for these growth-type companies. On average, however, RA found that the market tends to overpay for its expected earnings growth. What is important for the fundamental index is that it has a number to rebalance back to, which is the number in its fundamental weighting. RA uses trailing five-year fundamental factors, and the weightings change very slowly. The market, however, constantly changes its views on value, so when RA balances back to its fundamental weights, it doesn’t matter if there are slight structural sector over-weights or structural under-weights; what matters is that the fundamental portfolio balances back to its weights and captures that change of price based on the market’s expectation of the future.
Global Stock: Rolling 12-Month Average Country Weights
The differences in cap-weighting indexes and fundamentally weighted indexes also extend to global stocks, according to studies done by RA.
Figure 5-3 shows country weights in a capitalization-weighted index, and Figure 5-4 shows RA’s weightings in its All World Index, which includes the U.S., developed EAFE markets, and the emerging markets. RA builds a world stock universe and every stock is compared, no matter what country the stock is in. RA fundamentally weights the 3,000 largest companies into its index, and the weights change as the fundamental scores change for each company.
Figure 5-3. Country weights in a cap-weighted index. The index data published herein is simulated, unmanaged, and cannot be invested in directly. (Source: Research Affiliates)
In Figure 5-4, emerging markets, which is the top band, has gone from approximately zero percent weighting in 1984 to about 15 percent currently. This has generally followed the growth of the emerging markets’ participation in the world economy. Emerging market companies have steadily grown in terms of profits, dividends, sales, and book value relative to developed-country companies, and likewise its weight in RAFI has increased smoothly, just as it occurred on an economic basis. The cap-weighted index in Figure 5-3, by comparison, grew quickly in the early-to-mid 1990s and then collapsed in the late 1990s due to several negative events in the emerging markets, such as the Asian currency crises and the Russian currency crises.
Figure 5-4. Simulated RAFI target weight. The index data published herein is simulated, unmanaged, and cannot be invested in directly. (Source: Research Affiliates)
The other big story in global stocks is in the band that is second from the top, which represents Japan. In the cap-weighted index in Figure 5-3, by the late 1980s, Japan grew to be 50 percent of the world market cap. Japanese companies were expected to continue to grow, and many thought that their business models would end up taking over the world. Ten years later, in the late 1990s, they shrunk back to 10–15 percent of the world market cap. In an economic sense, Japan has been a stable part of the world’s economic size at about 15 percent.
In the cap-weighted graphic shown in Figure 5-3, investors would have ridden up with the Japanese bubble and then would have ridden it back down. In the RAFI graphic shown in Figure 5-4, there was a stable band through those years and no bubble.