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Wednesday, September 8, 2010

Old Wine In New Bottles ? Probably Yes But Those Bottles Look Better

Fortune has a gushing article about Robert Arnott and his  RAFI fundamental indexes available as large cap etf PRF and small cap etf Prfz

The article writes

Arnott's Big Idea is a concept he calls "fundamental indexing." It's a system that allocates money to stocks based on the economic footprint of the underlying companies rather than by the more common method of market capitalization. As we'll see, it's a near-revolutionary challenge to the accepted wisdom about passive investing. And it has already won over a range of large institutional clients, from the national pension fund of France to CalPERS, the $200 billion retirement fund for California's public employees. "Rob is one of a handful of guys on the cutting edge of investment thinking," says Dan Bienvenue, a senior portfolio manager at CalPERS. "In conventional indexing you're always average. Rob's method has historically beaten the average."

Arnott quickly concluded that companies weighted by size, using almost any criteria, consistently outperformed capweighted indexes.

The above is hardly a new discovery Eugene Fama has written about the size and value premium (using only book value) for decades and built the indexing firm Dimensional Financial Advisors (DFA) on index products using this methodology. Arnott just seems to have refined the technique by adding other factors.

For his index he settled on a formula that takes the average of four yardsticks: sales, cash flow, book value, and dividends. When companies pay no dividends, RAFI simply averages the other three. Over a 42-year span he found that a hypothetical index weighted by those four measures returned 2.1% more per year than cap-weighted funds.
The reasoning is well known: cap weighted indexes become concentrated in a small number of stocks with large market cap and usually high p/e values. In other words they are skewed to large growth stocks and in periods of high flying markets like the late 1990s are particularly prone to "bibble risk" In other words over the long run value beats growth (as both indexers and many many active managers have both found As the article explains:  The explanation in my view and that of many others far brighter than me is behavioral: investors become enamored of glamour stocks and pay too much for them:


Why do fundamental indexes fare far better? The principal reason is that they are regularly rebalancing their holdings by selling expensive stocks and buying cheap ones, relentlessly exploiting what's known as the "value effect." It's well established, both in academic studies and through decades of fund performance, that "value stocks," companies with low price/earnings multiples and low price/book ratios, perform better over time than expensive growth stocks that boast high P/Es. "The market does a good job choosing which companies will grow and which will shrink," says Arnott. "The problem is that investors pay too much for hot, glamorous growth stocks and set the bar too high." In the fundamental index, the rebalancing goes strictly by formula: When a company's market cap jumps faster than its sales or profits, the fund sells just enough of it so that its investment once again reflects not its price but its scale in the economy.
But as far as a revolutionary discovery in market behavior ...I'm with the view expressed here:

Arnott's critics claim that he's simply repackaging the value effect and calling it something revolutionary. "This is just old wine in new bottles," charges Cliff Asness, chief of hedge fund AQR Capital. "But I like the product." Arnott agrees that the value factor accounts for a lot of his outperformance but maintains his formula for systematically rebalancing into cheap stocks makes his fund far different, and far more original, than a cap-weighted value fund. "We're constantly trading against the market's most extreme bets," says Arnott
And in fact as others have noted the correlation between arnotts large cap and small cap indexes is extremely high (see below for the russell indices  it is close if not equal to 1.0 = 100% correleation) with the corresponding indexes from russell as well as with the the index funds from DFA. However correlation is not the whole story 3 funds can have high correlation but far different returns and on this count the Rafi index performances are quite impressive. Below are PRF (large cap)  and PRZ(small cap) compared to the corresponding etfs representing indices from S+P (spdrs), Russell (ishares) and MSCI (vanguard), The outperformance is impressive and consistent enough for me to make these two my choice for the large value and small value allocation in my portfolios.

Three Year  tables of total return:

Large Value

Correlation PRF and IWD Russell Large Value 3yrs of 60 day correlation

Small Value

Correlation PRFZ and IWN Russell Small Value 3yrs of 60 day corrwlation

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