The Fundamental Indexing Conundrum
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The document discusses research on fundamental indexing, which weights companies based on factors like sales, cash flow, book value and dividends rather than market capitalization. It summarizes backtests showing the fundamental index approach outperformed market cap indexes over decades. However, in the recent financial crisis, fundamental indexes performed poorly compared to benchmarks, due to high exposure to financials. This same exposure then led to outperformance during the recovery as financials rebounded strongly. Long-term, fundamental indexing appears to provide similar returns to market cap indexes but with less volatility due to avoiding bubbles in specific sectors.
The Fundamental Indexing Conundrum
- 1. The Fundamental Indexing Conundrum Gaetan “Guy” Lion April 2010
- 2. Introduction on Fundamental Indexing Robert D. Arnott develops fundamental indexes that weigh companies based on: 1) Sales (avg. over 5 years), 2) Cash flow (avg. over 5 years), 3) Book value (most recent), and 4) Dividends (avg. over 5 years). He starts an investment firm, Research Affiliates that launches with PowerShares several ETFs using his indexing methodology. The basic rational is to reduce exposure to bubbling stocks that are overweighed within a market cap index.
- 3. Thoughts… Fundamental indexes, being defensive, to fare better than market cap ones during Bear markets. Market cap indexes to fare better in Bull markets because they capture upward momentum. Over long cycles both approaches to generate similar returns.
- 4. Back testing Robert Arnott back-tests his (RAFI) indexes over decades. And, discloses his results (shown below) within his book:
- 5. The Debate Some say it is just Value investing. Others state this approach is flawed. A company with rising earnings of $5, $10, and $15 over past 3 years would have same weighing as one experiencing declining earnings of $15, $10, and $5. Proponents state it avoids market inefficiencies with specific sectors bubbling.
- 6. Empirical investigation Arnott launched his main fundamental index funds PowerShares FTSE RAFI US 1000 (large cap) and PowerShares FTSE RAFI US 1500 (small & mid cap) just a year before the 2007 Crash. This recent Bear market is a good test for the fundamental index approach. We will review the performance of both funds during the recent Crash and Recovery phases of the stock market.
- 7. Large Cap indexes correlation The large cap fundamental index (PRF) is slightly more correlated with value oriented indexes. We will compare PRF’s performance to the other indexes.
- 8. PRF vs S&P 500 in the recent Crash
- 9. PRF vs S&P 500 in the current Recovery
- 10. PRF vs S&P 500 since onset
- 11. PRF vs Russell 1000 (RUI)
- 12. PRF vs Russell 1000 Value
- 13. PRF vs Vanguard Value (VIVAX)
- 14. Table Summary for Large Cap The fundamental index fund (PRF) beat out handsomely the other benchmarks over the entire period by 2.3 to 5.1 percentage points in annual return. But, it did it by fairing poorly in the 2007 Crash and extraordinarily well in the 2009 Recovery. Level of risk (daily volatility) is similar.
- 15. Large Cap: Back Testing vs Actual The relative performance of the RAFI large cap was very different during the two periods . While in the 45 years of back testing, it excelled at besting the S&P 500 in Bear markets while recording only a small advantage in Bull markets; in the actual 4.25 years it faired poorly in the Crash of 2007. But, did extremely well in the Recovery of 2009.
- 16. Small Cap indexes correlation Fundamental index (PRFZ) correlation to value index or regular ones are equally high.
- 17. PRFZ vs Russell 2000 (IWM)
- 18. PRFZ vs Vanguard Small Cap Value (VISVX)
- 19. PRFZ vs Vanguard Midcap Value (VMVIX)
- 20. Table Summary for Small Cap The fundamental index fund (PRFZ) beat out the other benchmarks over the entire period by 7.2 to 8.0 percentage points in annual return. But, it did it by fairing poorly in the Crash and extraordinarily well in Recovery. PRFZ bears similar level of risk.
- 21. Small Cap: Back Testing vs Actuals The relative performance of the RAFI small cap was very different during the two periods . While in the 28 years of back testing, it excelled at besting the Russell 2000 in Bear markets while recording a smaller advantage in Bull markets; in the actual 3.5 years it faired poorly in the Crash of 2007. But, did extremely well in the Recovery of 2009.
- 22. A couple of questions… Why did the RAFI U.S. 1000 Large Cap did poorly in the Crash of 2007? Why did the same fund do so much better than its counterparts in the Recovery of 2009?
- 23. Explanation for poor performance in 2007 Crash: Growth vs Value… Large Value oriented index funds (including the RAFI funds) performed worse than traditional index funds during the Crash of 2007. Investigating the performance of a growth index fund vs a value index one may be interesting. Let’s look at Vanguard Growth Index (VIGRX) and Vanguard Value Index (VIVAX) that have long historical data going back to 1993.
- 24. Growth vs Value – the Overall Picture
- 25. The Dot.com bust A Value index being less exposed to the hi-tech sector with high P/E ratio performed much better than a Growth index.
- 26. The 2007 Credit Crash Now, the Value index performed marginally worse. This credit crisis emerged from the financial sector (banks, insurance) that is more prevalent within a Value index including the RAFI US 1000 fund.
- 27. Why did RAFI US 1000 do well in Recovery? Let’s look at sector allocations
- 28. 3 key sector allocation differences and performances during the recovery RAFI US 1000 is more heavily invested in Financials that did extremely well and less invested in Energy and Healthcare that did not do as well.
- 29. Parting thoughts The RAFI 1000 Large cap performed poorly during the 2007 Credit Crisis because of its large exposure to Financials. This same exposure to Financials caused it to fare extremely well in the 2009 Recovery. Investing in the RAFI 1000 Large cap may entail chronic sector bets including being overweighed in Financials (low P/E sector) and underweighed in Hi tech (high P/E). Such a fund will do well in any hi-tech bubble burst, but not so well in any financial/credit crisis. The RAFI 1000 Large cap has a steadier sector allocation than its market cap counterparts because it prevents specific sectors from bubbling. So far, there seems to be more than just a Value orientation to such funds. A longer actual record will prove informative in fully assessing the relative performance of RAFI funds.
- 30. Reference Appell, Douglas. (2007). “Fundamental indexing superiority disputed.” Pensions & Investments. April 30, 2007. Available on Internet. Arnott, Robert D. (2008). “The Fundamental Index.” John Wiley & Sons. Available at public libraries. Arnott, Robert D. (2005). “Fundamental Indexation.” Financial Analyst Journal. March/April 2005. Available on Internet. Kaplan, Paul. (2008). “Let’s Not All Become Fundamental Indexers Just Yet.” Morningstar Advisor. Spring 2008. Available on Internet. Perold, Andre F. (2007). “Fundamentally Flawed Indexing.” Financial Analyst Journal. November/December 2007. Available on Internet.