Disputing the superiority of fundamental indexing

BOSTON — Fundamental indexing — touted as a “better mousetrap” alternative to capital-weighted market indexes — won’t necessarily catch more mice, according to Harvard professor Andre Perold.
In a draft paper, “Fundamentally Flawed Indexing,” Mr. Perold, the George Gund Professor of Finance and Banking at Harvard Business School in Boston, argues that a pillar of the fundamental-indexing sales pitch — that cap-weighted indexes deliver “inferior” returns by overweighting overvalued companies and underweighting undervalued companies — doesn’t stand up to scrutiny.
Marshaling the same models and two-stock portfolios used by proponents to make their case, his paper concludes that the idea “that capitalization weighting imposes an intrinsic drag on performance is false.”
The argument that cap-weighted indexes deliver suboptimal returns has helped money management firms such as Research Affiliates LLC of Pasadena, Calif., and WisdomTree Investments Inc. of New York to garner billions of dollars in assets for strategies offering superior returns by using “fundamental” metrics such as dividend payouts and sales rather than market capitalization to determine a stock’s index weighting.

According to Research Affiliates, back-tested data show its fundamental indexes’ outperforming leading cap-weighted indexes by more than 2 percentage points a year for domestic-large-cap equities, by about 3.5 percentage points a year for international equities and by more than 10 percentage points a year for emerging-markets equities.
Robert D. Arnott, Research Affiliates’ chairman, said that his firm and its licensees, including Nomura Asset Management Co. Ltd., Pacific Investment Management Co. LLC and PowerShares Capital Management LLC, over the past 12 months have seen their fundamental-indexing assets under management surge to $9 billion, from less than $1 billion, with new inflows clocking in at about $1 billion a month.
Research Affiliates has a patent application pending for its non-capitalization-based indexes.
Jousting over assumptions
WisdomTree’s various fundamental-indexing-based exchange traded funds have gathered $3.5 billion in assets since the firm launched its first ETF offerings in June 2006, according to Jeremy Siegel, senior investment strategy adviser with WisdomTree and the Russell E. Palmer Professor of Finance at the University of Pennsylvania’s Wharton School in Philadelphia.
An initial wave of critics dismissed fundamental indexing as a glorified value-tilt quant strategy, but scrutiny of the theories behind the challenge to cap-weighted indexes is just now becoming more intense.
“A lot more people are looking at it more closely,” said Harindra de Silva, president of Los Angeles-based Analytic Investors Inc.
The debate finds proponents and critics jousting over a variety of assumptions, including how efficient capital markets are and how prices revert to fair value.
Mr. Arnott said that the outcome of the academic wrangling over fundamental indexing is important to him, as it “has a bearing on many of the core precepts of modern finance.”
The key point of his paper, Mr. Perold said, is that if nothing is known about fair value, then any stock, regardless of capitalization, is just as likely to be overvalued as undervalued.
Consequently, holding stocks in proportion to their market capitalization doesn’t systematically result in performance drag, he said.
Quant managers who have seen Mr. Perold’s paper said that it is a strong argument. To make the case for fundamental indexing, you have to presume that “large-cap stocks are overvalued, and you don’t know that,” said Eric H. Sorensen, president and chief executive of Boston-based PanAgora Asset Management Inc.
Value tilt
Mr. Arnott said that his firm’s composite-fundamental-index strategy, which uses dividend payouts, sales, cash flow and book equity value to determine a stock’s weight in the index, derives about a quarter of its value added from its dynamic value tilt, with dynamic size and sector tilts accounting for the remainder.
He called Mr. Perold’s critique of fundamental indexing “a little frustrating; in my view, he puts words into my mouth and then disproves what he says I say.”
Mr. Perold’s assumptions are consistent with efficient markets, and Research Affiliate’s assumptions are consistent with inefficient markets and the proposition that fair value isn’t infinitely uncertain, Mr. Arnott said.
In an interview, Mr. Siegel said that Mr. Perold’s arguments hold true under “a very restrictive set of assumptions” but fail on the most relevant points.
For example, Mr. Siegel said, even Mr. Perold concedes that fundamental indexing delivers superior returns if there is mean reversion in stock returns.
According to Mr. Perold, however, that mean reversion would allow fundamental indexing to deliver superior returns if it coincided with index re-balancing, but there is no reason to expect that to happen.
“We do not know which stock will mean-revert in the future, versus which will underreact in the future,” he said.
In the end, his paper attacks the proposition that investors can garner returns better than those of a cap-weighted index without relying on skill in distinguishing overvalued stocks from undervalued stocks, Mr. Perold said.
If fundamental-indexing proponents such as Mr. Arnott would say they “truly know something about market cap that is not reflected in current prices” and can improve on cap-weighted index returns, that would be a different story, Mr. Perold said.
“Of course, you are then in the realm of active management, and you should be held accountable to the same standards as everyone,” such as being judged by one’s live track record, Mr. Perold said.
In addition to his academic work, he is investment committee chairman for Boston-based HighVista Strategies LLC, which manages more than $1 billion for endowments, foundations, institutions and private clients in a diversified and integrated portfolio of marketable and alternative asset classes, including hedge funds and private equity.
Not giving in
Mr. Arnott isn’t ready to concede the argument.
His team at Research Affiliates is working on a paper on fundamental indexing, in tandem with Nobel laureate Harry Markowitz, that should come out soon, he said.
Mr. Markowitz was honored in economics for his pioneering work on modern portfolio theory.
Regardless of who wins the academic argument, some observers say, fundamental indexing could remain in demand.
Even if it is finally seen as a particular implementation of a value-oriented strategy, the fact that it is well constructed, transparent and a low-fee way of
capturing the market’s value premium will attract investors, Mr. de Silva said.