The Fundamental Debate

December 26, 2008

Robert Arnott
Robert Arnott


Paul Kaplan
Paul Kaplan





Few topics have captured the attention of index investors more during the past decade than that of fundamentally weighted indexes. The core idea is simple: Advocates of fundamentally weighted indexes argue that you can significantly improve the risk-adjusted returns of an index-based strategy simply by weighting the index by a factor other than price. Fans of traditional, market-cap-weighted indexes call that hogwash.

Recently, a debate was staged at the University Club in Chicago, Ill., between Robert Arnott—chairman and founder of Research Affiliates and one of the leading developers of noncap-weighted indexes—and Paul Kaplan, vice president of quantitative research at Morningstar, to get to the bottom of some of the biggest issues surrounding fundamentally weighted indexes, including:

  • Do they work?
  • Is it just value investing in disguise?
  • What are the flaws in the theory?

An edited transcript of their debate, moderated by Larry Siegel, director of research at the Ford Foundation, follows.

Larry Siegel, director of research, Ford Foundation (Moderator): Is fundamentally weighted indexing simply a value strategy or tilt, rather than a new way of thinking about capital market equilibrium? Tom Philips of Malbec Partners has pointed out that fundamentally weighted indexing is mathematically equivalent to a market-cap index, where that index has been reweighted to give a heavier weight to low price-to-earnings, price-to-book, price-to-sales, price-to-employees and so forth. How do you respond, Rob?

Robert Arnott, chairman and founder, Research Affiliates (Arnott): It would be very difficult to disagree with a mathematical truism. The Fundamental Index idea is a very simple idea. It involves weighting companies in a portfolio in direct proportion to the economic footprint of the company, measured by fundamental metrics of company size such as profits, sales, book value, dividends, or in our case, a blend of those. If you used, for example, a profits-weighted index, then by definition, weighting companies according to their profits is mathematically equivalent to weighting companies by market cap divided by their relative PE ratio. So the mathematical equivalence is undeniable.

I've said in the past that the Fundamental Index idea is a value strategy of a very specific sort, and it's one that suggests a change in our frame of reference, from a cap-weighted-centric view of the world, to a company-centric view of the world—one that weights companies according to how big and prosperous they are today, not based on how big they might be in the future.

Moderator: Paul, I'd like you to respond to Rob's comment about my first question.

Paul Kaplan, vice president of quantitative research, Morningstar (Kaplan): I think Rob and I are in complete agreement on this. This is a mathematical truism. It's a value-tilted portfolio. And what's interesting about it is—unlike traditional value indexes—it includes every stock in the market portfolio. It tilts towards the ones that have higher yields.

Moderator: Would you agree that fundamentally weighted indexing is in some sense a better approach to value indexing than previously constructed value index funds?

Kaplan: Different indexes are designed for different purposes. So, for example, at Morningstar, we've created value, core and growth indexes which divide the market into three segments. The first purpose of these indexes is to really monitor the market … to show how value did versus growth over the past month, quarter, year or five years. Another purpose of that type of index is diversification. If you own an active manager in growth, but he doesn't have any active ideas for value, you could use a pure-play value index. The Fundamental Index approach gives you an overall value tilt in a diversified portfolio. It is an intriguing idea because it does include all of the stocks.

The shortcoming that I see with it are that the weights are based upon variables like book value, earnings, dividends and so on, and there's no accounting for how much risk is in each stock. And that seems to run somewhat contrary to the usual kind of portfolio construction principles that we adhere to—that two stocks might have, say, the same expected future earnings growth, but we would want to put less weight on the one that's riskier.

Moderator: When I've tried to explain fundamentally weighted indexing to people who simply haven't heard of it, I've said, "There are two ways that you can earn a better return than the cap-weighted market. One is that you can look at information that other people don't look at, and that's what most security analysts try to do. Of course, there are so many security analysts that it's very hard to beat them. The other way—which seems to be a little easier—is to not look at information that everybody else is looking at. That information, in the case of fundamentally weighted indexing, is the price." Does this statement characterize your strategy fairly, Rob? And second, is there information in the price that investors should pay attention to that the strategy does not?

Arnott: I think the short answer to your question is yes. You've characterized the essence of the Fundamental Index approach, which is to strip price out of the weighting formulation. The reason to do that is that the price contains an error. We don't know what the error is. But we do know that every stock that's trading above its eventual fair value is weighted in the cap-weighted portfolio above that eventual fair value weight, and every company that's below its fair value is below its fair value weight. If you can just randomize those errors, that does add value.

But to your second part of your question, is there anything in the price that investors should consider that is not considered in the Fundamental Index approach? I would say your question answers itself. If there's information that's in the price, how do you profit from it? It's in the price!


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