Unexpectedly Intriguing!
15 June 2006

Last year, Political Calculations copied and pasted, ahem, presented Rob Arnott's speech discussing his research (available as a 408KB Word document) into the performance of stock market index funds whose composition of individual stocks is weighted according a fundamental business measure, such as aggregate revenues or book values, instead of the weighting stocks within the fund by market capitalization, as is done with major indices like the S&P 500.

Since then, Powershares Capital Management has launched an Exchange Traded Fund (ETF) based upon Arnott's indexing strategy, FTSE RAFI U.S. 1000 Portfolio (NYSE: PRF). The following chart illustrates the new ETF's performance with respect to the S&P 500, Nasdaq and Dow indices since its inception in December 2005:

As we can see in the chart above, the PRF index so far seems to offer somewhat better performance with less volatility than the price-weighted Dow and the market capitalization-weighted S&P 500 and Nasdaq indices. But this performance begs a question: if weighting individual stocks within an index according to fundamental business measures works better than traditional methods of weighting stocks in an index, why aren't there more such funds, including funds with different weighting metrics?

The answer is: they're on the way. Powershares plans to offer nine additional fundamental-weighted funds, but focused upon applying Arnott's fundamental-weighting technique to the individual sectors of energy, basic materials, industrials, consumer goods, health care, consumer services, telecommunications and technology, utilities, and financials.

Meanwhile, investment firm WisdomTree is seeking to create its own series of fundamentally-weighted indices, with significant input from Princeton professor Jeremy J. Siegel, author of Stocks for the Long Run and The Future for Investors. Siegel provides a taste of WisdomTree's pending offerings writing in the Wall Street Journal ($ only, excerpt via Econlog):

...According to my research, dividend-weighted indexes outperform capitalization-weighted indexes and are particularly valuable at withstanding bear markets. For example, the Russell 3000 Index lost almost 50% of its value between the bull market peak of March 2000 and the October 2002 low. Over this same period, a comparable total market dividend-weighted index was virtually unchanged. A dividend weighted index did have a bear market, but it only corrected by 20%. Moreover, the dividend-weighted index bear market didn't start until March 2002, and it lasted only six months (compared to 24 months for the cap-weighted index). The dividend-weighted index is now about 40% above its March 2000 close, whereas the S&P 500 and Russell 3000 are still not yet back to even. A similar performance occurred in other bear markets.

The historical data make an extremely persuasive case for fundamental indexing. From 1964 through 2005, a total market dividend-weighted index of all U.S. stocks outperformed a capitalization-weighted total market index by 123 basis points a year and did so with lower volatility.

But do these fundamental-weighted indices really offer better performance? Arnott suggests that "if his index had existed from 1962 through 2003, it would have beaten the S&P 500 by 1.9 percentage points annually." Jason Zweig notes:

For all of indexing's idiosyncrasies, Arnott's version just adds new ones. His emphasis on big companies with lots of physical assets and loads of employees gives his index a tilt toward value stocks, at least compared with the S&P. Who knows whether that stock-picking method will work as well in the next 42 years as it has in the past 42?

Writing in Kiplinger's Personal Finance, Steven Goldberg reports analyst Baie Netzer's conclusion that "the main reason the back-tested new index did so well is that it has a value tilt -- that is, it loads up more on undervalued stocks than does the S&P 500."

As Arnott is the first to point out, that's the point:

The index is intended to serve as a counterpoise to the S.& P. 500, which is weighted by market capitalization, or the stock market value of a company's outstanding shares. While the S.& P. 500 dropped by a cumulative 11 percent from 2000 to 2004, the RAFI notched a total return of 45 percent over the same five years, he said.

The S.& P.'s market-cap metric, he said, causes it to consistently overweight highfliers and to underweight bargain-priced shares. In that respect, the tail can wag the dog, causing the index to present a distorted picture of the market, he said.

"The S.& P. 500 gets whipsawed by every bubble when it inflates and when it deflates," he said.

Mr. Arnott says his index offers a better picture of the stock market's prospects because it underweights overvalued stocks and overweights undervalued shares.

Labels: ,

About Political Calculations

Welcome to the blogosphere's toolchest! Here, unlike other blogs dedicated to analyzing current events, we create easy-to-use, simple tools to do the math related to them so you can get in on the action too! If you would like to learn more about these tools, or if you would like to contribute ideas to develop for this blog, please e-mail us at:

ironman at politicalcalculations

Thanks in advance!

Recent Posts

Indices, Futures, and Bonds

Closing values for previous trading day.

Most Popular Posts
Quick Index

Site Data

This site is primarily powered by:

This page is powered by Blogger. Isn't yours?

CSS Validation

Valid CSS!

RSS Site Feed

AddThis Feed Button

JavaScript

The tools on this site are built using JavaScript. If you would like to learn more, one of the best free resources on the web is available at W3Schools.com.

Other Cool Resources

Blog Roll

Market Links

Useful Election Data
Charities We Support
Shopping Guides
Recommended Reading
Recently Shopped

Seeking Alpha Certified

Archives