Rob Arnott, the investment academic, thinks things look bad. He’s averse to both stocks and bonds. Perhaps, for the short run, TIPs may be a good investment. And utilities and financials later in the year. As for oil, who knows? Is it going to $60 or $160? So many things will determine how it fares—like geopolitical factors.
The more the government tries to intervene, he predicts, the worse things will get. The natural course of things should be allowed to play out—houses and stocks becoming cheaper. “Excesses being cleared away.”
Where is he investing? What you would expect from someone with (I suspect) a 200 IQ to invest? In something unexpected. Emerging-markets local currency debt.
Most of his talk in Morristown, N.J., the other day was devoted to fundamental indexes—stock-market indexes based not on market capitalization, like the Standard & Poor’s 500, but on other measures of a company’s economic size—total book value, dividends paid, sales, and profits. Not on a per-share basis, but as measures of a company’s total size.
Why are these other indexes better? Because a capitalization-weighted index stinks in the nostrils of God. It over-weights overpriced stocks and under-weights under-priced stocks. (Cap weighted=price times number of shares out there.)
As stock prices are driven up by greed, they become a greater portion of the index; as they are pushed down by fear, they become a lesser portion. The S&P 500 and other cap-weighted indexes keep getting more and more growth-oriented and less and less value-oriented.
Remember 2000 and 2001, when the S&P 500 got slaughtered? That was because its vastly overpriced tech holdings. Stocks in general did pretty well. “Few people,” Arnott said, “realize that 2000 was actually a bull-market year. Over those two years, there was a 40 percentage-point gap between the market and the cap-weighted indexes.”
Arnott was talking to a group of sophisticated investors, mainly CFPs. He asked: How many of you believe that it’s impossible to outperform a cap-weighted index? Nobody at all raised a hand.
For a cap-weighted index to be unbeatable and the market to be efficient (reasonably priced), he said, you have to believe that everyone is rational…there are no taxes or trading costs…everyone has the same risk-aversion…and so forth. “It’s a fantasy world,” he said.
True, most active money managers under-perform the S&P 500, he went on. So some people argue, “You see, we told you, the market is efficient.” But active investors’ investment costs have been their undoing, he poined out.
Arnott quoted John Bogle, Vanguard’s index-fund maven, as asking: Who knows which are the overpriced and which the under-priced stocks in the S&P 500? One answer, said Arnott, is an equally weighted index. Or just throwing darts at a list of stocks.
Actually, he argued, stocks are not always sensibly priced—because of errors. Arnott repeated again and again: Price is not necessarily fair value. One reason is “mean reversion”: High-priced stocks and low-priced stocks tend to return towards more neutral valuation multiples. Not exactly “efficient.”
If the market really is efficient, he asked, why is rebalancing such a powerful tool? Answer: Because rebalancing has you sell high and buy low. “But in an efficient market, rebalancing doesn’t make sense. There is no high, there is no low, there only is price, which is – by definition – correct. In an inefficient market, cap weighting is harmful.”
Equally weighting stocks is not practical, Arnott said, presumably because of a continual need to rebalance. Practical measures include weighting companies by their total sales, and in fact that measure alone has beaten a cap-weighted index by 2.5 percentage-points a year compounded over 30 years. Other indexes using different footprints are also better, like cash flow and dividends. Even weighting stocks by their number of employees outperforms “dumb old indexes.”
A study by Nomura in Japan, he reported, found that fundamental indexes beat cap-weighted markets in 23 out of 23 world markets.
Fundamental indexes actually do even better in smaller, more volatile markets, like emerging markets, Arnott went on. And they should do even better in microcap markets.
One can buy fundamental indexes through PowerShares, Arnott went on. He himself runs a fund, PIMCO Fundamental IndexPLUS TR (PXTIX), along with an asset-allocation fund that uses the Fundamental Index for its equity exposure, PIMCO All Asset Fund (PAAIX), a fund that Morningstar has called “compelling.”
Now, a chief rival of Arnott’s fundamental indexes are those of WisdomTree, which focus on dividends. Wisdom Tree hasn’t been doing well because it has been heavily invested (35%) in dividend-paying financials, which have gotten smeared. But Arnott joked that he isn’t ticked off by Wisdom Tree: If he gets the patent that’s pending, someday he might wind up owning it.
His own funds have been doing very well, Arnott went on, even in 2007, which was a growth year – even though his funds are somewhat value-oriented. And in 2005 and 2006, when value was in the ascendant, his funds “performed brilliantly.”
Arnott is a fine talker, able to toss off all manner of numbers without notes and nimbly answering some shrewd questions from his audience.
Arnott serves as chairman of Research Affiliates. He has written over100 articles for refereed journals, such as the Financial Analysts Journal, the Journal of Portfolio Management and the Harvard Business Review. He has received five Graham and Dodd Scrolls or Awards, awarded annually by the CFA Institute for the best articles of the year, and declined a sixth award during his tenure as editor. He was awarded two Bernstein-Fabozzi/Jacobs-Levy awards, by the Journal of Portfolio Management and Institutional Investor.
In 2002, he launched Research Affiliates to develop new products that he could bring to market through affiliations with distribution platforms throughout the world. His first affiliation was with PIMCO, serving as a sub-advisor, offering a global asset-allocation fund. More recently, he introduced the concept of Fundamental Indexation.
He has also served as editor of the Financial Analysts Journal, as visiting professor of finance at UCLA, on the editorial board of the Journal of Portfolio Management and two other journals. He graduated summa cum laude from the University of California Santa Barbara in 1977 in economics, applied mathematics and computer science.
The more the government tries to intervene, he predicts, the worse things will get. The natural course of things should be allowed to play out—houses and stocks becoming cheaper. “Excesses being cleared away.”
Where is he investing? What you would expect from someone with (I suspect) a 200 IQ to invest? In something unexpected. Emerging-markets local currency debt.
Most of his talk in Morristown, N.J., the other day was devoted to fundamental indexes—stock-market indexes based not on market capitalization, like the Standard & Poor’s 500, but on other measures of a company’s economic size—total book value, dividends paid, sales, and profits. Not on a per-share basis, but as measures of a company’s total size.
Why are these other indexes better? Because a capitalization-weighted index stinks in the nostrils of God. It over-weights overpriced stocks and under-weights under-priced stocks. (Cap weighted=price times number of shares out there.)
As stock prices are driven up by greed, they become a greater portion of the index; as they are pushed down by fear, they become a lesser portion. The S&P 500 and other cap-weighted indexes keep getting more and more growth-oriented and less and less value-oriented.
Remember 2000 and 2001, when the S&P 500 got slaughtered? That was because its vastly overpriced tech holdings. Stocks in general did pretty well. “Few people,” Arnott said, “realize that 2000 was actually a bull-market year. Over those two years, there was a 40 percentage-point gap between the market and the cap-weighted indexes.”
Arnott was talking to a group of sophisticated investors, mainly CFPs. He asked: How many of you believe that it’s impossible to outperform a cap-weighted index? Nobody at all raised a hand.
For a cap-weighted index to be unbeatable and the market to be efficient (reasonably priced), he said, you have to believe that everyone is rational…there are no taxes or trading costs…everyone has the same risk-aversion…and so forth. “It’s a fantasy world,” he said.
True, most active money managers under-perform the S&P 500, he went on. So some people argue, “You see, we told you, the market is efficient.” But active investors’ investment costs have been their undoing, he poined out.
Arnott quoted John Bogle, Vanguard’s index-fund maven, as asking: Who knows which are the overpriced and which the under-priced stocks in the S&P 500? One answer, said Arnott, is an equally weighted index. Or just throwing darts at a list of stocks.
Actually, he argued, stocks are not always sensibly priced—because of errors. Arnott repeated again and again: Price is not necessarily fair value. One reason is “mean reversion”: High-priced stocks and low-priced stocks tend to return towards more neutral valuation multiples. Not exactly “efficient.”
If the market really is efficient, he asked, why is rebalancing such a powerful tool? Answer: Because rebalancing has you sell high and buy low. “But in an efficient market, rebalancing doesn’t make sense. There is no high, there is no low, there only is price, which is – by definition – correct. In an inefficient market, cap weighting is harmful.”
Equally weighting stocks is not practical, Arnott said, presumably because of a continual need to rebalance. Practical measures include weighting companies by their total sales, and in fact that measure alone has beaten a cap-weighted index by 2.5 percentage-points a year compounded over 30 years. Other indexes using different footprints are also better, like cash flow and dividends. Even weighting stocks by their number of employees outperforms “dumb old indexes.”
A study by Nomura in Japan, he reported, found that fundamental indexes beat cap-weighted markets in 23 out of 23 world markets.
Fundamental indexes actually do even better in smaller, more volatile markets, like emerging markets, Arnott went on. And they should do even better in microcap markets.
One can buy fundamental indexes through PowerShares, Arnott went on. He himself runs a fund, PIMCO Fundamental IndexPLUS TR (PXTIX), along with an asset-allocation fund that uses the Fundamental Index for its equity exposure, PIMCO All Asset Fund (PAAIX), a fund that Morningstar has called “compelling.”
Now, a chief rival of Arnott’s fundamental indexes are those of WisdomTree, which focus on dividends. Wisdom Tree hasn’t been doing well because it has been heavily invested (35%) in dividend-paying financials, which have gotten smeared. But Arnott joked that he isn’t ticked off by Wisdom Tree: If he gets the patent that’s pending, someday he might wind up owning it.
His own funds have been doing very well, Arnott went on, even in 2007, which was a growth year – even though his funds are somewhat value-oriented. And in 2005 and 2006, when value was in the ascendant, his funds “performed brilliantly.”
Arnott is a fine talker, able to toss off all manner of numbers without notes and nimbly answering some shrewd questions from his audience.
Arnott serves as chairman of Research Affiliates. He has written over100 articles for refereed journals, such as the Financial Analysts Journal, the Journal of Portfolio Management and the Harvard Business Review. He has received five Graham and Dodd Scrolls or Awards, awarded annually by the CFA Institute for the best articles of the year, and declined a sixth award during his tenure as editor. He was awarded two Bernstein-Fabozzi/Jacobs-Levy awards, by the Journal of Portfolio Management and Institutional Investor.
In 2002, he launched Research Affiliates to develop new products that he could bring to market through affiliations with distribution platforms throughout the world. His first affiliation was with PIMCO, serving as a sub-advisor, offering a global asset-allocation fund. More recently, he introduced the concept of Fundamental Indexation.
He has also served as editor of the Financial Analysts Journal, as visiting professor of finance at UCLA, on the editorial board of the Journal of Portfolio Management and two other journals. He graduated summa cum laude from the University of California Santa Barbara in 1977 in economics, applied mathematics and computer science.
