Better beta strategy bridled by maverick risk

Rob ArnottCalPERS has led the charge in the adoption of fundamental indexing, but the concept has a long way to go before it challenges the conventional cap-weighted strategy. Michael Bailey spoke to chairman of Research Affiliates, and one of the originators of fundamental indexing, Rob Arnott.

Two words explain why no pension fund has yet installed a fundamental indexing strategy as the core of its equity portfolio, according to one of the concept’s originators, Rob Arnott – “maverick risk”.

The fund that has come closest to doing this is CalPERS, which views fundamental indexing as an enhanced index play, and recently approved a further expansion of its US$2 billion commitment to the concept. But that’s a drop in
the ocean in the context of a US$179 billion system.

Arnott is the chairman of Research Affiliates, which unveiled fundamental indexing in 2004 and has been criticised by efficient market theorists ever since. Fundamental indexing ignores the market capitalisation of a stock, and instead prioritises its holdings according to “real economy” factors like a company’s level of sales, book value, dividends and earnings.

Notables like AQR founder Cliff Asness have dismissed the concept as repackaged value indexing, however Arnott said this reflected a “cap-weighted centric” view of the world, because cap-weighted indexes will always load up on growth stocks trading above the market multiple.

Money has been run using Research Affiliates Fundamental Indexes (RAFI) since 2006, implemented by FTSE, and FTSE/RAFI’s All World 3000 and Developed 1000 indices beat their cap-weighted counterparts that year, as
well as in 2007 and so far in 2009.

Arnott took it as evidence of the depth of feeling against fundamental indexing when slight underperformance in 2008 – “a relentlessly wretched year for value all over the world” – was seized on by detractors as proof the concept did not work.

Despite their record of outperformance, Arnott said he was not surprised that no fund had replaced its cap-weighted core.

“If you’re managing a large pool of money, there are limits to how far you can stray away from convention. It’s sometimes referred to as maverick risk. Most people don’t want to take on enough maverick risk that an
idea or strategy would be abandoned in one bad year. So even those who view fundamental indexing as ‘better beta’ are likely to want to have diversified beta”.

However he takes consolation from the fact it took “about 15 years” from the introduction of a Standard & Poor’s cap-weighted index of US stocks in 1957 for any money to actually be managed on it, and “another 15 years before the amount of money that’s fundamentally indexed today was managed on a cap-weighted basis”.

There is US$20 billion fundamentally indexed globally today (out of a total market cap of US$40 trillion) but Arnott said he would be “stunned” if there was not US$30 billion in RAFI strategies by the end of 2009.

Arnott accepts that fundamental indexing remains more expensive than cap-weighted indexing. He estimated the RAFI range is priced anywhere from “half to one-third” of the equivalent active strategy, while cap-weighted indexing is more like one-tenth. But he says the gap is closing.  

“I was in a debate with [Vanguard founder and trenchant critic of fundamental indexing] Jack Bogle last fall, and he was saying ‘your strategies are so expensive’. I turned to him and said ‘Jack, when you first launched your S&P 500 index fund did you charge seven basis points?’ Discussion over.”