Could you add 2% more to your returns, just by structuring a fund or portfolio differently?
You can, according to Rob Arnott, a contributor to the 2006 book, “Just One Thing: Twelve of the World's Best Investors Reveal the One Strategy You Can't Overlook.” Edited by John Mauldin, the book provides a platform for a dozen leading investors to discuss their single best ideas.
Arnott, according to Mauldin, “becomes the smartest guy in the room just by walking into it.” He is the founder and chairman of global asset manager Research Affiliates. According to the firm’s website, Arnott co-manages two PIMCO funds, as well as staying active in the firm’s research, portfolio management and product innovation. In his work, he tries to bridge the academic and financial worlds.
His big idea is that a 2% annual gain is possible by switching from a capitalization-weighted fund to an equal-weighted or value-indifferent fund.
Arnott’s story begins with the capital asset pricing model, which is the model for many indexes and cap-weighted funds. The model provides a formula for figuring out the expected return of an asset based on its risk profile (also known as its fair value). In 2006, he wrote, “Many hundreds of billions of dollars are invested in index funds and cap-weighted indexes by individuals and institutions alike. This is a big deal.”
From there, he points out that all assets, including every stock, are going to trade above or below their true fair value:
“Now if every asset is trading above or below its true fair value, then any index that is capitalization-weighted (price-weighted or valuation-weighted) is automatically going to have us overexposed to every single asset that’s trading above its true fair value and underexposed to every single asset that’s trading below its true fair value. Far more than half of the index will be invested in the half of the market that’s overvalued, for the simple reason that the index weight of an asset is directly related to the size of the pricing error.”
Why does that have an effect on returns? When you invest too much in overpriced assets—and too little in undervalued assets—then you get what’s called a “return drag”. A capitalization-weighted portfolio is going to generate returns that are lower than portfolios made up of fair- or undervalued assets.
The alternative to a cap-weighted portfolio or index is one that is valuation indifferent, and thus free of the return drag problem. According to Arnott, “Even better, you can quantify return. It’s about 2 to 4 percent per year. How many managers out there reliably add 2 to 4 percent per year in the very long run? Darn few of them.”
An equal-weighted index is created by putting an equal amount of money into each stock, regardless of its stock price. Arnott added, “Although it’s a seriously flawed index, equal weighting will outperform a cap-weighted index.”
Although some see a small-cap bias as the source of advantage for equal-weighted indexes or funds, Arnott takes a different stance:
“What equal weighting does is to weight the portfolio in a valuation-indifferent fashion: It will underweight every stock that’s large, regardless of whether it’s cheap or dear, and overweight every stock that’s small, regardless of whether it’s cheap or dear. How does this compare with the cap-weighted index, where every stock that’s overvalued is overweight? In the equal-weighted index it’s random luck—50/50. You have even odds of being over- or underweight, whether it’s overvalued or undervalued.”
He then created a scenario in which the equal-weighted fund outperformed the capitalization-weighted fund by an average of 2.8% per year, even though the investor did not know which stocks were over- or undervalued (the random luck factor).
There is a size effect; large-cap stocks should typically underperform small-cap stocks, on average, over time. What’s more, the largest-capitalization companies should underperform the average stock. To back up that assertion, he cited a study he had published in the Financial Analysts Journal in 2005.
In that study, Arnott followed the returns of large-cap companies over one, three, five and ten years from a base year. He discovered that, "on average, over time, about 80 percent of the time, the largest-capitalization company underperforms over the next ten years... The magnitude of that underperformance is huge: The largest-capitalization company, on average, underperforms the average stock by 40 to 50 percentage points over the next ten years.”
According to Arnott’s research, the amount of underperformance or overperformance will fluctuate with the broader economy:
“During economic expansions, you add almost 2 percent a year. During recessions—when you most need those returns—we can add 3.5 percent. During bull markets, this approach adds 40 basis points. We add less in bull markets, because they are often driven as much by psychology than by the underlying fundamental realities of the companies. During bear markets, this approach adds 600 to 700 basis points per annum.”
Since Arnott’s article was published, the capitalization-weighted versus equal-weighted argument has continued, with both sides represented. For an example of a skeptical view, see “No Free Lunch From Equal Weight S&P 500,” and for a positive view, see “Cap Weighted Versus Equal Weighted, Which Approach Is Better?” Both articles are in Forbes magazine.
Conclusion
In this chapter of “Just One Thing: Twelve of the World's Best Investors Reveal the One Strategy You Can't Overlook,” Arnott made a case for buying or creating an equal-weight fund or portfolio rather than a capitalization-weighted fund.
The rationale for equal-weighting will seem intuitive to value investors, as it gets some undervalued stocks into the pool. Structurally, a cap-weighted fund will end up with more overvalued stocks and fewer that are undervalued. In the case of equal-weighted pools, an investor is more likely to have a balance between undervalued and overvalued.
And yet at the end, it appears to me to be a “free lunch,” and that’s the impression I get from Arnott as well.
Read more here:
- Just One Thing: Challenging a Risk and Return Myth
- Just One Thing: The Perils of Past Returns
- Just One Thing: Work With a Set of Investing Rules
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