Arnott: 'Little Things Make Big Things Happen'

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February 28, 2011
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There's no room for error in an era of 5 percent projected long-term equity returns.

 

Last June, we lost arguably the greatest coach the sporting world will ever see when John Wooden passed away three months shy of his 100th birthday. His track record was staggering—a record 10 national championships (including seven consecutive), 16 Final Fours, a record 88-game winning streak from 1971–73, and 8 undefeated perfect conference seasons.1 But his reach extends far beyond college basketball as his teachings formed the basis for several books about achieving success in life and business (a few of which can be seen in bookcases at Research Affiliates).

How did this paradigm of success begin the first practice of each new season? Perhaps some fundamental drills on dribbling, passing, and shooting? Actually, it began with socks. Asking all of his players to remove their shoes and socks, a bare-footed Wooden would proceed to instruct them on how to put on their socks and lace up their sneakers properly. Wooden explained that “…sweat socks, put on correctly, reduce the chance of blisters, which, in turn, ensures that a player can rebound—or shoot free throws or play defense—free from pain or distraction.”2 Such attention to detail was a hallmark of Wooden’s achievements. “These seemingly trivial matters, taken together and added to many, many other so-called trivial matters build into something very big: namely, your success.”3

Last month, we showed that five years of “live” results corroborate decades of similar empirical results for the Fundamental Index® methodology. Closing in on $50 billion in global assets, RAFI® investors and their advisers are sending a strong message that Fundamental Index portfolios merit strong consideration as a core holding. But success brings competition. New alternative beta variants have multiplied nearly as fast as assets invested in these strategies in recent years. Given the alternatives, one might ask, “What characteristics maximize the efficiency of a fundamentally weighted implementation?” In this issue we outline three seemingly innocuous construction details of the Fundamental Index methodology that can have sizeable impacts on performance.


Smoothing Fundamental Measures—Avoiding “Backdoor” Price Influences

People are often surprised when we explain that our Fundamental Index methodology utilizes trailing five years of financial data to determine fundamental weights.4 Why give any weight to 2006 data when we already have data from 2010? We understand that individual companies often experience results in a given year that are far ahead or far behind where they were five years ago. Google and Ford provide two vivid examples. However, history clearly shows that relying solely on the most recent financial information leads to worse performance than using stale data. Let’s examine why this somewhat counter-intuitive methodological detail adds value.

As Table 1 shows, smoothing data over five years adds more value than using the most current one-year financial data. Interestingly, the relative results improve as we add additional years. By the time we get to the “5-year” portfolio and its annualized excess return of 2.24%, an additional 17 basis points per annum accrues to “smoothing” financial results to five years from one. Incidentally, portfolio turnover also drops, as multiple years of data mitigate the trading impact of short-term swings in fundamentals.

 

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So why does old, stale data work better? The reason is relatively straightforward. The Fundamental Index advantage comes from breaking the link between price and portfolio weight, rather than from having the “right” weight. What drives price movements? Recent changes in financial results, which alter our expectations for the future! So, by using shorter term results to construct fundamental weights, we tacitly reintroduce price back into the equation, through the “backdoor.” This results in demonstrably worse returns.

 

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