Rob Arnott is no shrinking violet. That's a good thing. The editor of the Financial Analysts Journal and creator of the "fundamental index" concept has just come under fire from two of the biggest guns in indexing, Vanguard founder John C. Bogle and Princeton professor Burton G. Malkiel.
Writing in the Wall Street Journal, the two advocates of traditional indexing--- the use of indexes based on the market capitalization of stocks to reflect markets exactly as they exist--- assert that the indexing they champion will prevail.
They say fundamental indexing--- which constructs portfolios based on dividends, profits, book value, sales, and other fundamental data--- is just another "new paradigm," doomed to fade away. They go so far as to liken fundamental indexing to discredited fads like the "nifty-fifty" investments of the early '70s and the "government-plus" funds of the mid '80s.
Tough talk.
If institutional and retail investors are persuaded by their arguments, the growth of the Powershares RAFI 1000 exchange traded fund (ticker: PRF) may slow. The planned roll-out of a complementary international fundamental index fund could be delayed.
The Bogle/Malkiel attack certainly gave me pause. I wrote about the fundamental index concept in November, 2004 and described the newly launched RAFI 1000 fund as the first of the next generation of index funds in January. Yet Jack Bogle is one of my heroes. Burton Malkiel has been the most lucid advocate of the efficient market hypothesis for my entire adult life.
Was my enthusiasm for fundamental indexing unwarranted?
No, it wasn't. Let me tell you why.
Bogle and Malkiel complain that the fundamental index concept works to increase the weight of small capitalization stocks in the portfolio. It also works to bias the portfolio toward "value" stocks--- the stocks that tend to sell at lower multiples of earnings and book value. As proof, they point out that much of the performance advantage of the RAFI 1000 Index came in a single period--- 2000 to 2005, when small cap and value stocks trounced the S&P 500 Index by the widest margin in history.
If that was the only period of superior performance for the fundamental index, we'd have to worry that it was a one-shot wonder.
But Arnott's research shows something else. While small stocks and value stocks trounced the S&P 500 after a wildly excessive bull market, a close look at historical comparisons reveals that the fundamental index has an advantage in all markets--- but its advantage is largest when investors are more cautious.
While the RAFI 1000 Index (excluding expenses) beat the S&P 500 index (excluding expenses) by an annualized 2.07 percent a year from 1962 through 2004, it's advantage was only 0.47 percent in bull markets (vs. 5.92 percent in bear markets), only 1.61 percent during economic expansions (vs. 3.44 percent during recessions), and only 1.00 percent during periods of rising interest rates (vs. 3.09 percent during periods of falling interest rates).
One fact, however, is more important than the differences---
in all those circumstances the RAFI 1000 index did better that the S&P 500 Index. Better still, the RAFI index did it with slightly less price volatility. As a consequence, investors would have received more return with less risk, with great consistency. Indeed, the only time the S&P 500 beat the RAFI 1000 was the 90's, when the S&P 500 returned 18.6 percent to the RAFI 1000's 16.9 percent.
It's too short a period to mean much, but a quick comparison shows that the recently launched fund produced a total return of 4.8 percent in the first half of this year. That's well ahead of the 2.3 percent return of iShares S&P 500 index (IVV), the 2.1 return of the iShares Russell 1000 index (IWB), or the 2.4 percent return of the iShares Russell 3000 (IWV) index which includes the small cap universe.
Time will tell.
Meanwhile, I've added shares of this ETF to my brokerage window 401(k) account, my IRA account, and my taxable account.
They appear to live harmoniously with my shares of Fidelity Total Market Index and Vanguard Total Market Index.
On the web:
Sunday, January 22, 2006: Indexing just got a makeover
Sunday, November 28, 2004: Index funds--- the next generation
Sunday, November 28, 2004: Weight watching for funds
Wall Street Journal, Tuesday, June 27, 2006: John C. Bogle and Burton G. Malkiel, "Turn on a Paradigm?"
