Tag Archives: Fundamental Index

The Problem With Indexing

Indexing your investments is a good way to increase your chances of doing better than average. Most active investors trying to pick winning stocks (and avoid losing ones) don’t beat the index. Those who do are hard to identify ahead of time. Once you think you’ve identified a market-beating manager, they often allow their fund to get too big, which typically reduces their chances of repeating their past success. And sometimes they’re on the cusp of retirement. Or they’ve lost analysts who’ve helped them be great. In other instances, you might be correct in thinking they can outperform over the long term, but you’re about to capture one of their fallow periods. Nobody ever said this game was easy.

Yet, there are problems with indexing too. “Indexing” generally means following what’s called a “capitalization weighted” index. That means the rank of the stock in the index is determined by how much the stock market values it. Market capitalization is the total shares of a stock outstanding multiplied by the price per share. But is taking the stock market’s verdict about where a stock should be ranked in an index reasonable? Many people think it isn’t. After all, you necessarily own more shares of the most favored and possibly expensive stocks in a capitalization weighted index.

When the first index fund – the Vanguard 500 Index Fund – came to the market in the early 1970s, academic finance was dominated by the notion that the market prices stocks properly – or accurately, based on available information – at all times. That made it seem reasonable to rank stocks by how the stock market says they should be ranked.

But there’s a case to be made that ranking stocks based on their underlying companies’ economic fundamentals such as sales, earnings, dividends, and book value might also be reasonable. And if stock markets don’t always set prices properly, if they are sometimes the victims of emotion gripping their participants, maybe focusing on economic fundamentals of the businesses is a smarter approach to indexing. And, after all, if you rank stocks based on companies’ underlying economic fundamentals, you’re arguably not showing any disrespect for markets. You might just be elevating the markets for companies’ goods and services over the market that trades those companies’ stocks.

An easy way to “break the link” (as Rob Arnott, founder of fundamental indexing, puts it in describing all “smart beta” strategies) between market capitalization and index rank of a sock is to start with a capitalization weighted index, but then rearrange it in a way that equally weights the stocks. No attention to underlying economic fundamentals needed.

This is the subject of a new paper published by Standard and Poor’s. First, the paper documents the outperformance of equal-weight indexes compared to their capitalization weighted equivalents. According to the paper the S&P 500 Equal Weighted Index has outperformed the S&P 500 Index by 2.1 percentage points. Moreover, this outperformance or “alpha” exists in international markets as well.

How much money is 2 percentage points annualized? It can amount to $50,000 in a scenario that’s not difficult to imagine for an ordinary investor. For example, if you invest $5,000 for 25 years and earn 5% annually on the investment, you’ll wind up with just under $340,000. If you invest the same amount for the same time frame, but earn 7% annualized instead of 5% annualized, you’ll wind up with just under $390,000.

The most obvious reason for the outperformance of the equal-weight index is its greater exposure to smaller stocks. The plain S&P 500 Index is concentrated at the top. Only 10% of the names – 50 stocks – account for nearly one-half of the index’s total weight, and the largest 30% of stocks – the top 150 – account for 75% of the total weight. Conversely the smallest 40% — the bottom 200 stocks – account for only 10% of the index’s total weight.

An equal-weight index will elevate the exposure to the smaller stocks in the index, and this “size bias” explains a “considerable portion of the S&P 500 Equal Weight Index’s long-term returns,” according to the paper. Another smaller part of the explanation is related to the fact that the equal weight index undergoes periodic rebalancing. This means that stocks that have done well are periodically sold and stocks that have done poorly are purchased to keep the fund’s allocation equally weighted to the 500 stocks. So equal weighted indexes have a kind of “anti-momentum” strategy. And while momentum is viewed as a legitimate factor that can beat a plain index, so does an anti-momentum strategy. In fact, performance of the equal weighted index relative to its capitalization weighted counterpart can indicate how momentum is faring overall in markets in a given period, according to the paper. When momentum is doing well, the equal weighted strategy tends not to do well, and vice versa.

Another feature of an equal weight index is how it treats the sector components of the index. During the technology bubble of the late 1990s, technology stocks began to overwhelm the index in the sense of becoming a larger and larger component of it. And although an “equal-weight index effectively allocates to each sector in proportion to the number of stocks held in that sector,” according to the paper, this is enough to mute the bad or overwhelming effects that a sector run-up can have.

Overall, the evidence suggests that an equal-weighted index captures a greater share of the stocks that achieve above-average returns. This doesn’t mean such a fund should be the only stock holding in a portfolio. For example, it can complement trend-following or relative strength strategies, helping to increase a portfolio’s volatility-adjusted returns when used that way. An equal-weight strategy can also mute the tendency of a low volatility strategy to go through periods of underperformance.

Although the paper doesn’t characterize a capitalization weighted index this way, its analysis begs the question of whether such an index is itself a kind of a momentum strategy. In any case, investors should be mindful of the problems inherent in plain capitalization weighted indexes especially at a time when indexing is garnering so many investor dollars. Capitalization weighted indexer will do fine over time, if investors can stick with the approach through thick and thin. But, at some point, they might wonder why they didn’t consider alternatives.

A Day At The Beach, Part 2 — Global Asset Allocation

See Part 1 – Here

In this second installment relating my trip to the Research Affiliates Advisor Symposium in Newport Beach, CA, I will discuss the firm’s second major line of research, which involves the appraisal of global asset classes. The firm manages the PIMCO All Asset (PAAIX), and All Asset, All Authority (PAUIX) funds. These are global asset allocation funds that seek the maximum real return, often by emphasizing non-mainstream asset classes. The funds own stocks, bonds, commodities, and currencies through underlying PIMCO funds. Over the long haul, the goal of All Asset is to beat TIPS and inflation by 5 percentage points, while the goal of All Asset, All Authority is to beat the S&P 500 and inflation plus 6.5 percentage points. Research Affiliates thinks these inflation goals are tall orders currently.

For example, a glance at the asset allocation part of the firm’s website shows that U.S. stocks are poised to deliver no return over inflation over the next decade. Stocks from developed countries, by contrast, are expected to deliver a little more than a 4% annualized real return, and those from emerging markets are expected to deliver nearly a 6% annualized real return. Besides emerging markets stocks, no asset class, save private equity, is likely to deliver more than a 5% real return.

First, Chris Brightman, CIO of Research Affiliates, led the attendees through the firm’s asset class returns. Bonds returns, of course, follow starting yields closely throughout history with a correlation of 0.96 between starting yields and future 10-year returns. Similarly, strong correlations exist globally.

In equities future returns follow starting earnings yields, using the inverse of the CAPE Ratio (Price relative to the past decade’s worth of real average earnings). The correlation between starting earnings yields and subsequent 10-year returns is 0.75 since 1926, though admittedly, returns have been higher lately. Again, similar correlations exist in other countries.

The current level of the CAPE implies a roughly 80% overvaluation of stocks. Other metrics, including Market Capitalization relative to GDP, Tobin’s Q, and Hussman’s PE show similar overvaluation. There’s hardly a way to look at US stocks, and not conclude that they are overpriced. Among Western developed countries, only the UK appears as if it is priced to deliver a real return of more than 5% for the next decade.

 

A Demographic Interlude

During his talk, Brightman speculated on why valuations seem to be higher than in the past. He remarked that macroeconomic volatility is lower today than it’s typically been in an agrarian economy where bad weather can wreak economic destruction. There are arguably lower risks in a post-industrial economy, and perhaps this is properly reflected in lower return prospects. There is also a greater ease in investing with the advent of index funds and ETFs; it’s easier to obtain a more diverse, lower-cost portfolio.

Brightman also made a demographic observation – an increasing percentage of older people in an economy tends to lower productivity growth. This, in turn, has an influence on real rates of return. Brightman used the example of teenagers who consume a lot and produce nothing. But when teenagers get to be, say 25 years old, the rate of change in their productivity from the time they were 15 is extremely high. Similarly, there is a great rate of change in productivity from the ages of 25 to 35. But then there is a lower rate of change from 35 to 45, and after 45 there is no difference in growth. Then, when adults become old, they revert to being teenagers again – consuming a lot, but producing little. The difference is that teenagers have parents and senior citizens have assets – and that’s why asset prices are higher and return prospects lower.

All of this means that the U.S. enjoyed a period of superior growth as the baby boom generation matured and entered the work force. In other words, the post-war demographic trend flattered the superior growth of that period, and without similar demographic trends, the growth likely can’t repeat. It’s possible that stocks can deliver higher returns if earnings-per-share growth increases, but for three or four decades the ratio of profits to GDP has been growing. Brightman was skeptical that corporate profits could continue growth faster than the economy because, if that trend continued, it would likely violate rules of social equity. It’s likely that corporate profits will not grow faster than GDP from this point.

 

Non-Mainstream, Better Beta, and Rebalancing

Investors have a few options to boost returns. First they can consider non-mainstream stocks and bonds. Emerging markets, as previously mentioned, are poised to deliver higher returns than financial assets from developed countries. In fact, Rob Arnott, in his talk on after-tax returns, volunteered that one-third of his liquid net worth is in emerging markets equities. Second, investors can potentially extract greater returns from low-returning asset classes by using smart beta strategies such as fundamental indices. Capitalization weighted indices can’t deliver excess returns, and active management cannot collectively beat the market. Third, investors can rebalance diligently across asset classes instead of buying and holding, which tends to overweight recent winners. “Tactical over-rebalancings,” as Brightman puts it, can help boost returns.

Brightman’s three recommendations make me think investors need good advisors now as much as ever. Individual investors aren’t always comfortable choosing non-mainstream asset classes. They also aren’t as able to pick smart beta funds as they are plain index funds. Moreover, investors aren’t likely to pick the best smart beta funds, which, as Brightman’s colleague FeiFei Li noted, are not always characterized by the lowest expense ratio. Last, advisors are probably better equipped to accomplish the rebalancing that Brightman thinks will be a significant part of a successful investor’s future returns.

A Day At The Beach, Part 1

I’ve just returned from the Research Affiliates Advisor Symposium in Newport Beach, California last week. If the cloudy and sometimes rainy weather disappointed some of the attendees, the conference itself didn’t. As I reflect on it now, it stands as one of the finest investment conferences I’ve attended. This will be the first in a three-part series on the conference.

The argument against traditional indexing

Before I talk about the conference, a few words about Research Affiliates are in order for readers who aren’t familiar with the firm. Research Affiliates is the company of Robert Arnott who is the author of influential papers on investing and a former board member of the Jounral of Portfolio Management. Arnott arguably devised the first “smart beta” stock strategy which he calls the “fundamental index.” Instead of ranking stocks in an index based on market capitalization, which is how most index funds function, the fundamental index ranks them on four economic factors of the stocks’ underlying businesses – sales, cash flow, dividends and book value. In other words, the fundamental index or “RAFI” (Research Affiliates Fundamental Index) “breaks the link,” as Arnott puts it, between a stock’s rank in an index and its market capitalization or price. In fact, that’s what all smart beta strategies do; they are all based on some newly devised “beta” or index that doesn’t rank stocks based on their price or market capitalization. I like Arnott’s approach because it forces investors to think of stocks as ownership units of businesses and to rank stocks based on characteristics of their underlying businesses.

Products that use the fundamental index include the PowerShares FTSE RAFI US 1000 ETF (PRF) and the PIMCO RAE Fundamental PLUS Fund (PXTIX). Other funds apply fundamental indexing to foreign stock markets. Arnott’s insight that capitalization weighted indexes necessarily give an investor more exposure to more expensive stocks and his research into other forms of index construction started the smart beta revolution. Other “factors” or characteristics of groups of stocks that could help those stocks beat the market – namely small and value —  were identified in a famous paper by Eugene Fama and Kenneth French. While Dimensional Fund Advisors took its bearings from the Fama/French research and built funds with capitalization weighted indexes that it tilted toward small-cap and value stocks, nobody created an alternative index or helped create funds that were invested in one until Arnott.

One award-winning academic paper has argued that the fundamental index has a “value bias” making the PowerShares fund’s S&P 500 Index-matching performance over the past decade, when value has underperformed growth, striking. (Arnott also classifies his index as value-oriented on the smart beta portion of the Research Affiliates website.) The PIMCO fund has outperformed the index by more than 300 basis points annualized, but it’s structured differently than the PowerShares fund. The PIMCO fund gains exposure to the fundamental index through a derivative, which it colateralizes with a bond portfolio. So it has two sources of return – the fundamental index and the bond portfolio that PIMCO manages in an effort to overcome the price of the derivative.

Since the development of products using the fundamental index, other funds with other “factors” have hit the market. Along with plain capitalization weighted index funds, smart beta funds have been attracting assets in droves while traditional active managers mostly bleed capital. But there aren’t as many factors that can consistently beat capitalization weighted indices as marketers might have you think. The “factor zoo,” as Research Affiliates calls it, may be well populated, but only a few species are worth much. Those are value, size, income, momentum, low beta, and quality. In some of its papers, Research Affiliates isn’t even sure “quality” is a legitimate factor, although the firm includes it in its factor appraisals on its website.

Not All Factors Are Equal — Or Always Well-Priced

The question about which factors might be overpriced comes from an argument about data mining. Most factors reflect data mining or observance of a one-time bump in valuation that isn’t sustainable. This has caused a public argument between Research Affiliates and Clifford Asness of AQR Management. If illegitimate factors are the result of a one-time or random bump in valuation, legitimate factors that have persistence can get expensive too. Furthermore, those factors can be embraced or shunned – in effect, timed — based on their relative historical valuations. By contrast, Asness thinks investors are better off sticking with a factor or two they like rather than trying to time them.

Parts of the conference addressed the valuations argument. Research Affiliates thinks momentum and low-beta or low-volatility strategies are expensive. That makes sense given that some investors have driven up the prices of Facebook, Google, and Amazon, and others have sought stock exposure with lower volatility in the aftermath of the financial crisis.

Most value strategies, on the other hand, are relatively cheap. They have suffered as Facebook, Amazon, Apple, Netflix, and Google have propelled growth and momentum indices higher in recent years. But investors might be wrong to choose the factors that have performed the best. Research Affiliates Head of Investment Management, FeiFei Li, gave a presentation showing among other things that choosing the worst performing smart beta factors can lead to better performance than choosing the best performing ones. Valuations are predictive of future returns. In other words, contrarian smart beta investors looking for a “reversion to the mean” might overweight value over momentum based on how each factor is priced relative to its history on the Research Affiliates website.

Li also argued that investors should look at how smart beta funds implement their strategies, because implementation can have a much greater effect on returns than the expense ratio. In particular, high turnover, low weighted-average market cap, and a low number of holdings can be warning signs to investors that a fund isn’t implementing its strategies in the most cost-effective ways.

Morningstar’s Director of Global ETF Research, Ben Johnson, followed Li’s talk with some similar themes. Johnson argued that re-framing factor investing as an evolution of active management was useful. Many traditional stock pickers use factors that characterize ETFs, just not as systematically and mechanically. Johnson also warned investors to be wary when funds with similar factors are introduced at once. That can be an indication that a factor has had a run that’s probably not repeatable.

In my next installment, I will report on the portions of the conference that were concerned with global asset allocation and asset class valuations.