Is Rob Arnott a Mad Genius, or Just Mad?

So Rob Arnott took the advice of John Bogle and started his own firm and developed a new product.  Bogle comes back and dismisses the product as "witchcraft" and a marketing gimmick.  Arnott's product outperforms Bogle's by over two percentage points per year over the 5 1/2-year lifetime of Arnott's product.  An Investment News article shares this and additional stories about Rob Arnott and his firm, Research Affiliates.

Research Affiliates developed its product, Fundamental Indexing, to address what appeared to Arnott a conundrum: traditional cap-weighted indexes tended to be overweight stocks whose prices had risen faster than their fundamentals would indicate.  At the very least, it did not make sense to invest more money in the most expensive stocks available in a market.  So Arnott and Jason Hsu, Research Affiliates' CIO, set out to devise an alternative weighting strategy.  They settled on a scheme that uses four metrics, each weighted equally: cash flow, dividends, sales, and book value.  The testing indicated that the weighting scheme works to improve performance.

The objective was to give less weight to stocks that may be overvalued relative to their fundamentals.  What emerges is a portfolio that has a distinct value tilt.  So Eugene Fama's quote in the article above is correct, that fundamental indexing captures the value effect.  The approach is definitely passive though, using variables that related to the company for weighting all of the stocks in a traditional index.  (Research Affiliates has applied it techniques to the FTSE indexes to date.)

Now, Research Associates is turning its attention to bonds, intending to use the 3 Ds for weighting purposes, deficits, debt, and demographics.  Of course these are the primary inputs into credit analysis for corporate bonds.  They can also be applied to sovereign debt.  It again provides a disciplined framework for avoiding a excessive allocation to to an issuer who has already borrowed a large amount relative to its ability to service that debt.

The equity strategy is available in an open-end mutual fund format from Schwab and in an ETF from PowerShares.  I use the RAFI funds in my Clarity Portfolios to provide a bit of alpha to overcome fund expenses.