In 1970, Eugene Fama, a finance professor at the University of Chicago, propounded the Efficient Market Hypothesis (EMH), which says that at any given time, prices fully reflect all available information on a particular stock or group of stocks. According to the EMH, no investor has an advantage in predicting returns on stocks since every market participant has access to the same information.
Three years later, Burton Malkiel, a Princeton economics professor, published A Random Walk Down Wall Street. In it, Malkiel holds that stock price changes are normally distributed and are independent of each other, so past movement cannot be used to predict the future.
In the 1970s, sophisticated investors combined these two concepts and developed “indexing.”The driving notion behind it is this: If price movements are random, and if the market prices already reflect all available information, then why go to the trouble and expense of research and trading? Why not just buy the market?
In 1976, mutual fund giant Vanguard started its Vanguard 500 Fund, which holds all 500 stocks in the S&P 500 index. That fund is now the largest of all stock funds, with more than $107 billion in assets at the end of 2005. Altogether, Vanguard’s major U.S. stock index funds now hold nearly a quarter trillion dollars of investor assets. And Vanguard is only one of many players in the index game.
The trouble with indexing
Indexing, or “passive,” investing, sounds simple. However, a serious problem became apparent in the late 1990s. The S&P 500, like almost all major market indexes, is capitalization weighted. This means the proportion of each stock in the index is determined by the market capitalization of that stock (that is, the number of shares multiplied by the recent price) divided by the total market cap of all stocks in the index. If you hold a fund indexed to the S&P 500, then as the price of a given stock rises, its portion in your portfolio increases.
As tech stocks soared in the late 1990s, their market caps increased dramatically and they came to dominate supposedly diversified index funds. At the end of 1999, fully one-fourth of your S&P 500 index fund consisted of just 10 stocks: Microsoft, General Electric, Cisco, Wal-Mart, Exxon, Intel, Lucent, IBM, Citigroup and America Online. Six years ago, these 10 companies had a combined market cap of $3.1 trillion. Today it’s less than $1.7 trillion. The overvaluation of the most popular stocks during the late 1990s has placed a drag on returns for index fund investors ever since.
So is there a better way of indexing? One promising alternative leaves the basic market capitalization system in place but uses some readily available quantitative methodology to screen out stocks whose valuations appear excessive. This approach is not new—“value index” funds have been around for more than a decade.
Does value indexing work?
To determine whether this method could increase returns or lower the risk of index investing, I began a research project. Using only point-in-time data (data available at the time of decision making, not in hindsight) for large cap stocks going back to 1987, I constructed hypothetical portfolios in which stocks were divided into equal groups based on five different factors: earnings, book value, cash flow, dividends and dividend growth. Upon analyzing the data, which now covers 19 years, the results are clear. By eliminating stocks with higher price-to-earnings ratios, or by eliminating those with little or no dividend growth, investors can significantly improve their returns.
For his latest book, The Future for Investors, Wharton Professor Jeremy Siegel conducted a similar analysis of point-in-time data for S&P 500 stocks dating back to 1957. His conclusions: both dividends and price-to-earnings ratios matter. Siegel stresses the importance of dividends and urges readers to avoid what he calls the “growth trap” of investing in “glamour” (or high price-to-earnings) stocks.
Fundamental indexing
A second alternative for improving index returns foregoes the use of market capitalization. At the forefront of this movement is Rob Arnott, head of Research Affiliates LLC and editor of the prestigious Financial Analysts Journal. In an article published last year, Arnott identifies what he views as a critical problem with a cap-weighted index portfolio: Given that the future is uncertain and the true fair value of any stock is unknown at any given time, market cap weighting mathematically assures one’s portfolio will be overweighted in overpriced stocks and underweighted in underpriced stocks.
In the article, Arnott compared the investment performance of cap-weighted indexes with indexes that weight position sizes according to company revenues, book value, dividends, cash flow and total employment—what he calls “fundamental indexing.” Using point-in-time data covering 1962 through 2004, Arnott found that a composite index constructed from four of these factors—revenues, book values, cash flow and dividends—produced returns about 2 percent better annually than the cap-weighted S&P 500 index.
Investors have two ways to access Arnott’s fundamental indexing. PIMCO offers two open-end mutual funds, the Fundamental Index PLUS and the Fundamental Index PLUS Total Return, that track the “RAFI 1000 Index” (RAFI stands for Research Affiliates Fundamental Index). Available only since June 2005, these two funds have already gathered more than $500 million in assets. Because of how they’re managed, these funds can generate significant ordinary income, so they’re probably best purchased in a tax-deferred account.
A more tax-efficient way to bet on Arnott’s fundamental indexes is through an exchange-traded fund (ETF) called PowerShares RAFI US 1000 Portfolio (ticker symbol PRF). PRF began trading in December 2005, but it’s already gathered $60 million in assets.
Critics of fundamental indexing include heavyweights Gus Sauter, head of indexing at Vanguard, and Ken French, professor at Dartmouth. Generally, they say Arnott’s method simply shifts the cap-weighted broad market index to “smaller cap” and “value.” But if, as many have pointed out, small cap and value have outperformed the broader market (as measured by cap-weighted indexes) over the long haul, is that really a criticism? My money is on Arnott.
This column is not intended as investment advice. You should consult your own adviser in determining whether to incorporate any of the opinions expressed here in your investment decisions.
David Raub has 16 years’ experience as a registered investment adviser. He is co-owner of Raub Brock Capital Management in Larkspur. You can reach him at draub@northbaybiz.com.
