Thursday, 20 May 2010

Book Review: The Fundamental Index by Robert Arnott, Jason Hsu & John West

Ground-breaking ideas with hugely valuable investment potential combine with a critical gap, but it is a must-read for every individual investor. In a revised edition with the additions and fixes that I suggest below, I daresay this would be the most important investing book since Burton Malkiel's A Random Walk Down Wall Street.

The Fundamental Index is a way of forming an investment portfolio that weights its component stocks not according to the traditional market capitalisation of each stock but according to a combination of the size of sales, cash flow, book value and dividends of companies, which the authors term as being their economic weight.

The book claims that investing by the Fundamental Index (in capitals because the authors have trademarked the term through their company Research Affiliates, which commercializes the resulting RAFI indexes) will produce higher long term returns than investing using passive cap-weighted indexes such as the S&P 500. That claim is backed up in convincing fashion with actual past returns going back to the 1960s, with discussion of the flaws of cap-weighting and its under-lying assumptions and with rebuttal of the often-strident criticisms thrown at the method by some quite-distinguished (like an economics Nobel winner or two) academics.

Along the way, there is a very useful discussion of how to estimate future stock returns, as well as results for developed and emerging market countries, including Canada, all but one of which (Switzerland) showed Fundamental Indexing outperforming cap-weighting. The authors address what kinds of situations (bubbles aka stock market returns over 20% per year) and changes (pricing errors do not happen in the first place or do not get eliminated / no reversion to the mean; market becomes systematically and persistently pessimistic and under-prices future actual fair value).

The first and lesser flaw in the book is that their rebuttals of criticism are framed in general terms and not at specific published critical writings, most notably that of André F. Perold, Finance Professor at Harvard, in Fundamentally Flawed Indexing. From reading and re-reading that paper and then various passages in the book, it appears that the whole foundation of the Perold criticism, never mind the mathematical elegance of the "proof", lies in the critical assumption which the Fundamental folks deny, stated best in the book's Foreword by their Nobel winning supporter Harry Markowitz: "... classical finance theory is largely built on a foundation of efficient markets under CAPM assumptions, which implies that future prices are randomly distributed around current price. We are subtly changing this assumption. In fact, we are assuming the opposite: current price is randomly distributed around fair value."

The major gap is the too-brief and incomplete discussion of how the Fundamental Index works in practice - considering expense ratios, trading costs, tracking errors and taxes of actual ETFs or mutual funds that apply the concept. An index is not an investable product that an investor can buy. If the practical costs and performance drags outweigh the performance gain there is no advantage for an investor. (My own limited examination of US Fundamental ETFs suggests that there is still about 1% per year difference.) Related is the fact that an investor who seeks to diversify and take advantage of the value and small cap effects must buy and juggle several more funds so a portfolio comparison of costs would alter the calculation again. Finally, the correlation of Fundamental Indexes with other asset classes needs to be laid out so that investors can see how to fit them properly into a portfolio. Adding this material in another edition would fully earn the book its sub-title "a better way to invest".

I used to believe, like the current critics, that Fundamental indexing was nothing more than a value tilt. Well, the book has changed my perspective. It's a value tilt with differences - first, it includes all stocks from the whole market all the time, instead of separating Value from Growth and second, it dynamically adjusts the amount of tilt according to the gap between stock market prices and the fundamental factors (e.g. refusing to follow bubbles on the way up).

The text reads smoothly, there is lots of illustrative material in helpful charts and tables (and no math). Well footnoted and referenced, it provides the background and under-pinning references to sell the case (but not the articles critical of Fundamental Indexing).

The Research Affiliates website has other Fundamental Index publications a link to other reviews of this book here.

Because of its missing pieces, the book earns 4 out of 5 stars. For its ideas, the book earns 6 out of 5 stars, for an average of 5 out of 5.

5 comments: said...

Jean, it is worth noting that the degree of inefficiency in a market amplifies the excess return of a fundamental index versus the cap-weighted commensurate. Your own analysis looked at the most efficient market in the world, and still found value add.

But if you look to less efficient markets (i.e. emerging markets), you will find tremendous value add (around 10% annualized, 8-9% after expenses, taxes, tracking etc.).

You should look up Arnott's paper on Clairvoyant Value - fascinating stuff... Great ideas out of Research Affiliates.

Trivia: they have a first edition of The Wealth of Nations in their lobby.

Jordan said...

Jean, after reading the book does this change your view on portfolio asset selection? Is the book convincing enough for you to change your own portfolio? Would you include a fundamental index with or instead of a traditional cap-weighted index?

CanadianInvestor said...

>Preet, yes I have read the Clairvoyant paper and it puts another nail in the cap-weight coffin - it's good material for a post.
>Jordan, yup, I have gone for it hook, line and sinker. My equity portfolio is now all RAFI (new post on that to come and I plan to put another tracking spreadsheet on my blog at the bottom to see how my portfolio will compare with my former cap-wt version). The asset allocation question is a very good one and I would like to see Arnott et al analyze the inter-action of RAFI equity with other asset classes. The book does say RAFI and cap-wt correlation is in the high 90s, which means RAFI should function much the same but I always like to see the data.

Jordan said...

Wow good for you for making a clear choice. After reading the book I seem to be stuck in the middle. I think the fundamental index makes a lot of sense, but I still have some concerns so I've ended up basically splitting all of my asset classes between cap weighted indexes and RAFI. It's a bit more of a pain in the ass to manage.

Stephen Pinner said...

after reading this book it completely changed my views on portfolio asset selection I now am only online trading and never again doing it the wall street way.

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