Archive for April, 2014

ROBERT ARNOTT: A Better Mousetrap?

April 12, 2014


April 11, 2014

Be Open To New Investment Ideas But Don’t Bet The Farm On Them

-Fundamental Indexation – Weights stocks based on key fundamentals, not price.
-Fundamentals can include revenues, earnings, cash flow, book value, dividends, etc.

ROBERT ARNOTT: Celestial Chase

April 11, 2014

ROBERT ARNOTT: Celestial Chase

What does Financial Thought Leader and portfolio manager Arnott do to unwind from his intensive schedule of research, investing and financial innovation? He describes his “geeky hobby.”

Watch the related WEALTHTRACK Episode.


April 11, 2014

Consuelo Mack: This week on WealthTrack, is there such a thing as a better mousetrap to capture higher market returns? This week’s financial thought leader guest says his fundamental index innovation catches more money for investors. Research Affiliate’s founder and Chairman Robert Arnott explains his fundamental index approach next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. One of our goals on WealthTrack is to help our audience become better investors. Put simply, we want you to get more bang for your hard earned buck. Every once in a while a new idea or innovation comes along that helps you do that. I would count John Bogle’s creation of the index fund as one of them. Jack as he is known to many of his colleagues created the first index fund at his firm Vanguard in 1975. His concept was to allow the average investor to invest in the broad market at a very low cost. It took years to catch on but has it ever! Equity index funds, including the newer exchange traded funds or ETFs now account for 31% of total equity fund assets. $2.7 trillion worth versus the $6.1 trillion in actively managed funds… And the momentum is accelerating. Since the financial crisis in 2008 investors have put nearly a trillion dollars into index funds and taken more than 300 billion dollars out of actively managed stock funds. As Bogle points out that is a cumulative shift in investor preference of more than 1.2 trillion dollars. My issue with index funds has always been why do we have to settle for market performance? Why in the glorious history of human accomplishment is investing the one area where average is really the best that we can do?

Another problem is that traditional index funds are what is known as capitalization weighted, which means the more expensive the stock and greater the number of shares outstanding the bigger weighting they have in the index. So at the peak of the tech bubble in 1999 technology stocks as a percentage of the S&P 500 index had gone from a weighting of 11% in 1989 and for much of the next decade, to more than 25% by 1999. If you were invested in Bogle’s original Vanguard 500 index fund you were tech heavy at the peak and got hurt when the sector crashed. So is there a better mousetrap? Today’s financial thought leader guest says there is. He is Robert Arnott chairman and CEO of Research Affiliates, which he founded in 2002 as a self described, “research intensive asset management firm that focuses on innovative products”. Among the unconventional portfolio strategies that he has pioneered are tactical asset allocation and the fundamental index approach to indexation. Fundamental indexes weight companies based on their fundamentals such as sales, cash flow, book value and dividends. I began the interview by asking him to describe his major criticism of the traditional Bogle market-cap weighted index fund.

Robert Arnott: Firstly it was a wonderful innovation. Active managers cancel each other out. If I’m overweight one stock relative to the market, somebody else has to be underweight, so these active bets cancel. If I’m winning, there has to be a loser on the other side of the trade, and so this was a wonderful insight on his part to say, “Okay, I’m not going to play that game. I’m just going to own the market and, oh, by the way, if I just own the market, I can do that for almost nothing, almost free, almost no turnover, almost no brokerage commissions.” My goodness. What an amazing insight, and yet it has a huge Achilles heel. The Achilles heel is that every single stock that is overpriced, the weight in the portfolio is higher than it should be. Every stock that’s underpriced, the weight in the portfolio is lower than it should be, and those areas don’t cancel. It means that the majority of the portfolio is in companies that are trading above fair value. A minority is in companies that are below their fair value, and those don’t cancel. They create a drag on the portfolio performance. Well what if you could have no such drag? You could do that with darts.

Consuelo Mack: Right. The Burton Malkiel, the monkey throwing darts at a …

Robert Arnott: Burt Malkiel way back when he wrote …

Consuelo Mack: Wall Street Journal page.

Robert Arnott: Yeah, when he wrote A Random Walk Down Wall Street, he said a monkey throwing darts could do as well as a professional money manager, and Burt Malkiel was wrong. A monkey throwing darts, we’ve proved it, can do better.

Consuelo Mack: So I take the Wall Street Journal which used to have daily all of the quotes in the New York Stock Exchange, and a monkey throwing darts could do better than your average equity mutual fund manager?

Robert Arnott: Absolutely. Well, the average equity mutual fund manager earns the market return minus their costs, because for every winner there’s a loser, but we did a paper entitled Upside-Down Strategies and Malkiel’s Monkey in which we took an array of strategies, fundamental index being one, minimum variance being another, and an array of other strategies, and for good measure we threw in Malkiel’s monkeys, random strategies, and we tested them all. And then we took these well-known beloved alternative strategies and we turned them upside-down. fundamental index; instead of putting the most in the companies that were the biggest, we put the most in the companies that were smallest. Minimum variance; instead of the companies that were least volatile, we put the most in the companies that were most volatile, that kind of thing. They all worked.

Consuelo Mack: And they all outperformed the market cap weighted indexes. Which is what…

Robert Arnott: They all worked, and the reason they all worked was that every last one of them, the fundamental index, the minimum variance, the monkeys, every last one of them set the weight in the portfolio in a fashion that ignored price, ignored market capitalization and did not get sucked into the game of putting more money into a company just because the price had gone up.

Consuelo Mack: Of course, the monkey didn’t do that intentionally. It just randomly happened that way.

Robert Arnott: Of course. Of course.

Consuelo Mack: So let’s go back to in layman’s terms. Number one, was there any catalyst? Was there any aha moment when you said the market cap weighted indexes, for all the reasons you just said, are not appropriate anymore? They don’t work well for investors. Was there anything?

Robert Arnott: The catalyst really was the tech bubble and its aftermath. During the 1990s I thought for a long, long time, why do we weight portfolios on market cap? Doesn’t that just channel our money into the most expensive, the most popular, the most beloved companies, the most vulnerable companies, the companies that are most dangerously expensive? And then after the tech bubble crashed, a dear friend of mine, George Cain, came to me and said there’s got to be a better way. I’d long been thinking, why don’t we weight portfolios based on a company’s sales or its book value? You’re still going to get concentration in big companies. You’re still going to get representation of the broad macro economy, except instead of studiously mirroring the look and composition of the stock market, you’re going to studiously mirror the look and composition of the economy. It’s still going to have nice low turnover. It’s still going to have …

Consuelo Mack: Low costs.

Robert Arnott: Low costs. It’s still going to have a portfolio that represents something meaningful, the broad economy. So something that had been percolating in my mind for years, I thought, why don’t I test it, and I was expecting it to add a few tens of basis points. My first …

Consuelo Mack: To performance versus the market.

Robert Arnott: To performance relative to the market because I knew it would have a value tilt, and I knew value tilts were going to add some value. My very first test was on basically something akin to a Fortune 500 index. Fortune 500 has been around since the mid ‘50s, and they choose the 500 largest companies by sales. Well, if you take those companies and weight them by sales, how does it perform? We tested it back to the early ‘70s, and we found two and a half percent per year compounded value add for over 30 years. Oh, my goodness. That’s when I realized we were on to something big, because that’s a huge margin of victory. Most active managers would happily sell their grandmother to get that kind of incremental return.
Consuelo Mack: So the fundamental indexation, that term means that the index is based on fundamentals as opposed to stock price.

Robert Arnott: It’s based on fundamental size of a company…

Consuelo Mack: Okay, so it’s size.

Robert Arnott: not price, size, and it’s based on selecting the company based on size and weighting the company based on size.

Consuelo Mack: And you’re measuring size, and I remember you had kind of four main criteria at one point. Right? You had sales, and you had book value.Robert Arnott: Sales, profits.

Consuelo Mack: Profits.

Robert Arnott: Book value and dividends.

Consuelo Mack: And dividends. Are those the core criteria that you’re still using today?

Robert Arnott: They don’t have to be. They don’t have to be. Those are the constituents of the FTSE RAFI index. Russell has the Russell fundamental index. They use sales adjusted for debt equity ratio. They have retained profits, profits after dividends have been paid out, and then they have dividends adjusted for stock buybacks. So they approach it from a different angle, but they’re still fundamental measures of the financial size of a company. We have a relationship in Taiwan where they use number of employees as the size of a company. This is for a government pension, and because there’s a desire to reward companies for employment, well, why not weight the index based on employment? It works just as well.

Consuelo Mack: Give us an example of how a fundamental index looks that’s different from what I would know is a traditional index, and I’ll start with Jack Bogle’s original based on the S&P 500, the Vanguard 500. So how is your equivalent, which I think would be the Schwab Large Cap Index, how does that look different?

Robert Arnott: Marvelous case in point, Apple. Apple is the number one market capitalization company in the U.S. It’s not the biggest business in the U.S., not by a long shot. It doesn’t even make the top 20 by most measures. It’s a moderately large business.

Consuelo Mack: So in the S&P 500, the cap weighted, that would have the largest weight. Right?

Robert Arnott: It has the largest weight because the shareholders, the market believes that Apple’s share of the future economy is going to be immense, and the market may be right, but you’re prepaying for it now as if it will be right.

Consuelo Mack: Because price is based on expectations.

Robert Arnott: Right, and so you’re prepaying for it as if that is already fact. Now, let’s suppose the market’s right. Okay, you’ve already prepaid for it. So it has to be right. It has to become the largest business in the world in order to justify current prices, and if …

Consuelo Mack: Whereas the fundamental index looking at Apple …

Robert Arnott: The fundamental index looking at Apple says, okay …

Consuelo Mack: The value is in how.

Robert Arnott: Right. Says it’s about 20th largest business in the United States; therefore, it’s about our 20th largest holding, and if the market’s wrong, let’s suppose the market’s only a little bit wrong and it’s fifth largest business in the world 10 years from now, then the price is too high. It’ll under- perform, and fundamental index by dint of having it at 20th largest weight will out-perform. What’s the largest business in North America and, arguably, in the world? Exxon Mobil.

Consuelo Mack: Exxon Mobil.

Robert Arnott: So that’s our largest position. Well, that’s fine. Does it have to get bigger to justify its current weight? No. What’s an example of a company that is much bigger than the market gives it credit for? Bank of America. It’s certainly in the top five in terms of businesses in North America by almost any …
Consuelo Mack: By sales, by profits, by …

Robert Arnott: Almost any measure you want to choose, and yet the market puts it roughly 20th by market capitalization. So the market is basically saying this company faces so many challenges that it’s going to shrink by more than half in the years ahead, and maybe the market’s right. Maybe it’s right, but if it shrinks by less than half, then it’s going to be an out performer. So fundamental index doesn’t win by predicting what’s going to happen. It wins by dint of serving as an anchor to contra-trade against the market’s constantly changing expectations. If BofA grows in price, fundamental index will say, “Oh, thank you for those gains. Let me trim a little and get back to the fundamental scale of the business.”

Consuelo Mack: Which you do, what, every year.

Robert Arnott: Every year.

Consuelo Mack: You’re reconstituting it every year based on, again, these fundamentals.

Robert Arnott: Right, and actually we do a quarterly partial reconstitution, so we move a fourth of the way each quarter back towards the fundamental scale, and if BofA stubs its toe and craters in price, fundamental index will say, “Oh, thank you for the lower price. It’s still a big company. We’ll top up back to its fundamental scale,” and so you’re contra-trading against the market’s constantly changing views, and you’re turning that volatility into incremental return.

Consuelo Mack: Obviously, fundamental indexation has some critics.

Robert Arnott: It sure does.

Consuelo Mack: As Jack Bogle did as I mentioned earlier, and a recent GMO white paper, which is Jeremy Grantham’s firm, it was titled No Silver Bullets in Investing (just snake oil in new bottles), and its criticism of fundamental indexation and other now called smart beta strategies, which we’ll talk about that term in a minute, basically said that in your portfolio construction that you are guaranteeing what you just described, a tilt to value in small cap stocks. “Traits which have known to perform better over time, so this brilliant idea” … again, these are these words … “about how to beat cap-weighted benchmarks is really about a value in small cap oriented strategy, i.e., it’s no new strategy at all.” So what’s your response to that criticism?

Robert Arnott: Well firstly, the piece was written by James Montier. I have a huge regard for Montier. I’ve known him for years. He’s brilliant. Does not mean he’s always right. Now in this particular case, he is largely right. Fundamental index earns most of its incremental return by dint of what are called the Fama-French factor tilts, size tilt, value tilt.

Consuelo Mack: Right. Eugene Fama. Right. Nobel Prize winner.

Robert Arnott: Now, what’s interesting is those factor tilts are based on the fact that value tends to win over time, the fact that small cap tends to win over time. To match the exact factor tilts of the fundamental index would require owning the Fama-French long-short portfolios and adjusting them on the fly to match the constantly changing bets of the fundamental index.

Consuelo Mack: Okay, you’ve already lost me there, Rob. (Laughs) Sounds way too complicated for an index.

Robert Arnott: So in plain English, fundamental index wins because it’s contra-trading against the market’s biggest bets. So in a very, very simple way, just by looking like the broad macro economy and contra-trading against the biggest bets, it captures the dynamic, constantly changing opportunity set of the market.

Consuelo Mack: So it does have a value tilt.

Robert Arnott: It does have a value tilt. It sometimes has a small cap tilt, meaning that when the market is paying a big premium for big cap stocks, we’re going to favor small cap stocks. When the market is paying a big premium for small cap stocks, Montier doesn’t get this. He doesn’t understand this. We’ll have a large cap tilt. We do right now, and so our tilts change. They’re dynamic. Whatever the market’s paying the most for, that’s what we’re betting against, and that also means since the market’s always paying a premium for growth and always paying a discount for value, it will always have a value tilt. So he’s got that right.

Consuelo Mack: Okay, so aside from Fama-French, Gus Sauter, who is the retired chief investment officer at Vanguard, said in a recent article in the Wall Street Journal that, number one … because I’m thinking, what’s wrong with the value in small cap tilt if, in fact, that’s what it is, and you’re saying it changes according to the market, but value, yes. But he would say, well, then you’re much better off just buying a value-oriented index fund and a small cap-oriented index fund, putting them together in your portfolio. It’s cheaper, and you’re better off doing that. What about that as an alternative strategy to yours?

Robert Arnott: It is cheaper. It’ll save you maybe 15 basis points, 15 hundredths of a percent, not a big deal. It’ll also under perform over the life of fundamental index. The idea was launched back in2005. Fundamental index over that time has beat the market by around two percent a year compounded. How much of a tailwind have we had from value beating the market? None.

Consuelo Mack: None.

Robert Arnott: Value’s under performed. So you could have bought that value index fund and under- performed, and you would have paid a lower fee for it.

Consuelo Mack: A lot of firms are coming out with what they’re calling smart beta products. What’s the pitfall with smart beta?

Robert Arnott: Well firstly, we’ve been credited with the term smart beta. We didn’t invent it. It was actually invented by a consulting firm out of the U.K.

Consuelo Mack: How much attention should I pay to that term as an investor?

Robert Arnott: Smart beta, as a way of capturing a strategy, is a really neat idea, and I feel a certain I guess you’d call it an avuncular pride in having opened the door for a whole array of very interesting strategies, many of which have outperformed the market handily since their launch and done so at fees far lower than active managers charge. Well, that’s marvelous. If you can win relative to the market and save your clients money on fees, on trading costs, that’s a win-win outcome. So I’m delighted to see this idea gain traction. Fundamental index is one of the few of the so-called smart beta ideas that looks like the broad market, looks like the broad macro economy, has low turnover, has vast capacity and can accommodate truly vast assets.

Consuelo Mack: Right, and you are applying fundamental indexation to just about every asset class under the sun, stocks, bonds, emerging markets, small cap, large cap, growth, value, you name it. Right?

Robert Arnott: And it’s about one of the only ones that’s fast-approaching a 10-year track record. So that’s very exciting. The idea works. Now, apropos of Montier’s comment, it’s not going to work every year. When growth is on a roll, when the market’s paying more and more for the high multiple growth stocks, we have a headwind, but when it’s doing that, we’re going deeper and deeper into value, and so when value snaps back, we earn it back and then some, and that’s exciting.

Consuelo Mack: One investment for a long-term diversified portfolio. None of our guests can recommend any of their own products. What would you have us own?

Robert Arnott: Emerging markets have fallen deeply out of favor lately. There is no such thing as a bargain that isn’t accompanied by fear. Fear creates bargains, so when people say, “Aren’t you afraid of emerging markets?” that’s why they’re cheap. The value end of the spectrum in emerging markets is the cheap end of the spectrum. That’s fundamental index in emerging markets. Growth has been the outperforming end of the spectrum. Emerging markets value, aren’t you afraid of emerging markets value? That’s why that end of the spectrum is cheap. I think that’s the one stock market area that’s interesting. Emerging markets bonds also I think are very interesting. The credit quality is much better than most people realize, and the interest rate spread over the developed world is tremendous.

Consuelo Mack: Thank you, Rob Arnott from Research Affiliates, and thank you for explaining fundamental indexation and smart beta because we are going to be hearing a lot more about that as investors.

Robert Arnott: Thank you for having me on.

Consuelo Mack: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point: Be open to new investment ideas but don’t bet the farm on them. Fundamental indexation makes sense on several fronts. It weights the stocks in its indices based on several key financial fundamentals instead of just stock price. Owning more or less of companies based on factors like the size of their revenues, reported earnings, cash flow, book value and dividends sounds reasonable to me. And according to Arnott’s research, fundamental indexes have outperformed traditional cap weighted ones by an average of 2% a year over the last 50 years. Jack Bogle’s original index fund concept was greeted with derision and skepticism by Wall Street. His cap-weighted index funds are now widely accepted as at least a part of every portfolio. It’s worth considering the new fundamental approach to the indexation theme.

Next week we are going to have a television exclusive with a mutual fund manager who is considered to be one of the top stock pickers of all time. CGM Focus Fund’s Ken Heebner will join us to discuss his bold, contrarian strategy and extreme performance!

And also we are introducing a new feature on our website. It’s called “WealthTrack Women”. Investment pros who specialize in advising women clients will answer questions vital to their financial health.

Have a great weekend and make the week ahead a profitable and a productive one.


April 11, 2014

Is there such a thing as a better mouse trap? This week’s Financial Thought Leader guest has created an alternative to traditional index funds. Instead of being based on market capitalization or stock price, his Fundamental Index® approach measures fundamentals such as sales, profits, and dividends to determine the weight securities have in his indexes. Research Affiliates Chairman and CEO Robert Arnott explains why fundamentals can make a big difference. Continue Reading »

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