Response To Arnott’s Fundamental Indexing

May 10, 2017

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Ben Lavine, chief investment officer of 3D Asset Management based in East Hartford, Connecticut

As a preview to his scheduled presentation at the upcoming Inside Smart Beta ETF Conference (June 8-9), Rob Arnott, founder and CEO of Research Affiliates, sat down for an interview with Inside ETFs’ John Swolfs. In advocating for his fundamental indexing methodology (“RAFI”), Arnott made some provocative statements I believe warrant a counter-response.

First, a quick overview of the RAFI methodology, or “Fundamental Indexing.” According to Research Affiliates, RAFI seeks to “sever the link between price (market capitalization) and portfolio weights” using alternative, fundamental measures of company value or their “economic footprint.”

The original footprint comprised a company’s sales, cash flow, book value and dividends, but has since evolved to include other measures such as delivered sales, dividends/buybacks and retained cash flow, depending on the index series (FTSE/Russell is the primary index provider for RAFI).

In addition, the RAFI methodology underpinning the PIMCO Fundamental IndexPLUS strategy incorporates net operating assets, debt coverage ratios and buybacks. The impetus for developing RAFI came in response to the late 1990s internet bubble market and its subsequent collapse, which led Arnott to explore other index weighting methodologies that didn’t leave the investor exposed to high-valuation, high-momentum stocks.

However, in reaffirming the case for Fundamental Indexing, Arnott argues that RAFI should serve as the standard for how investors invest in equities rather than market capitalization. In other words, RAFI, rather than market capitalization, should serve as the baseline anchor for equity allocations within an investment program.

Is Market Capitalization Inherently Flawed?

First, Arnott identifies what he believes is a fundamental flaw in market capitalization:

“[Rob Arnott]: While capitalization weighting makes an assumption that market prices are correct, intuitively they're not. The price of any stock represents its fair value, plus or minus an error. The market may judge the price too high, it may judge it too low. The market is constantly trying to figure out whether the price is too high or too low. In the very long run, the errors are mean-reverting; they correct over time ...”

But I would argue the opposite; namely, that market capitalization is intuitively correct, even as it constantly corrects forecasting errors of fair value. At its core, market capitalization encompasses the Wisdom of the Crowds or the aggregate assessment of the fair or intrinsic value of the constituent equities comprising the index.

Dividend discount modeling (or the Gordon Growth model) represents the most basic form of measuring intrinsic value. The model incorporates: 1) the present (or current payout); 2) the future (growth of that payout); and 3) the risk/uncertainty (discount rate) of realizing Nos. 1 and 2. Sure, the model is susceptible to input “error,” but that susceptibility is diminished due to the networking effect of the vast number of amateur and professional participants making such intrinsic value estimates.


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