The international newspaper of money management April 30, 2007
Claim of cap-weighting’s drag on return is ‘false’
Posted: April 30, 2007, 6:01 AM EST
Fundamental indexing — touted as a “better mousetrap” alternative to capital-weighted market indexes — won’t necessarily catch more mice, according to Andre Perold.
In a draft paper titled “Fundamentally Flawed Indexing,” Mr. Perold, the George Gund Professor of Finance and Banking at Harvard Business School, 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, Mr. Perold’s paper concludes by saying 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, Pasadena, Calif., and WisdomTree Investments Inc., New York, 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.
Research Affiliates says back-tested data show its fundamental indexes outperforming leading cap-weighted indexes by more than two percentage points a year for large-cap domestic equities; by roughly 3.5 percentage points a year for international equities; and by more than 10 percentage points a year for emerging market equities.
Robert D. Arnott, Research Affiliates’ chairman, said his firm and its licensees, including Pacific Investment Management Co., Nomura Asset Management Co. and PowerShares Inc., have seen their fundamental indexing assets under management surge over the past 12 months to $9 billion from less than $1 billion, with new inflows clocking in at roughly $1 billion a month. Research Affiliates has a patent application pending for its non-capitalization based indexes.
Jeremy Siegel, senior investment strategy adviser with WisdomTree and the Russell E. Palmer Professor of Finance at the University of Pennsylvania’s Wharton School, said 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.
Scrutiny intensifies
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 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.”
Mr. Perold said the key point of his paper 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 say it’s 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 officer of Boston-based PanAgora Asset Management Inc.
Value tilt
Mr. Arnott said 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 roughly a quarter of its value added from its dynamic value tilt, with dynamic size and sector tilts accounting for the remainder.
Mr. Arnott 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 Mr. Perold’s arguments hold true under “a very restrictive set of assumptions” but fail on the most relevant points. For example, he says, even Mr. Perold concedes that fundamental indexing delivers superior returns if there is mean reversion in stock returns.
Mr. Perold replied that mean reversion would allow fundamental indexing to deliver superior returns if it coincided with index rebalancing, but there’s no reason to expect that to happen. “We do not know which stock will mean revert in the future vs. which will underreact in the future,” he said.
In the end, Mr. Perold says his paper is attacking the proposition that investors can garner better returns than those offered by a cap-weighted index without relying on skill in distinguishing overvalued stocks from undervalued stocks.
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, said Mr. Perold. “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, he said.
In addition to his academic work, Mr. Perold 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 Harry Markowitz, that should come out soon, he said. Mr. Markowitz won a Nobel Prize for his pioneering work on modern portfolio theory.
Whoever wins the academic argument, some observers say fundamental indexing could remain in demand. Even if it’s finally seen as a particular implementation of a value-oriented strategy, the fact that it’s well-constructed, transparent and a low-fee way of capturing the market’s value premium will attract investors, said Mr. de Silva.
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