Morningstar Advisor - Winter 2008 - 55

Active managers have argued for ages about the right way to beat the market, while much of the indexing world has been content to simply match the market. Not that that’s a lowly goal, 14000 what with the vast majority of active managers failing to simply keep up with their bogys. 13000 But the indexing world has been somewhat topsy-turvy lately. The preponderance of ETFs11000 is forcing more differentiation among index 10000 providers, and a growing chorus of investors now argues that traditional market-capweighted indexes are faulty. From DFA to WisdomTree, these purveyors of indexing strategies are all laying claim to “the right way to index.” But perhaps nobody has garnered as much attention as Robert Arnott of Research Affiliates. The former editor of Financial Analysts Journal prefers to weight companies according to factors such as their sales, book values, cash flows, and dividends, while ignoring market cap. The strategy, on display at offerings such as PIMCO Fundamental IndexPlus Total Return Inst PXTIX and PowerShares FTSE RAFI US 1000 PRF, has13000 quickly caught the attention of investors who 12000 were burned by the performance of traditional market-weighted indexes during the last bear 11000 market. 10000 Others, however, have been less welcoming. Vanguard founder John Bogle and Vanguard index chief Gus Sauter have both lambasted the strategy, equating it to another case of performance chasing. After all, Arnott’s methodology leads to portfolios that have thus far favored small-cap and value stocks at precisely the time that such stocks have enjoyed a strong run of outperformance. conversation has been edited for clarity and length. Kunal Kapoor: The issue that’s on the top of a PIMCO Fundamental IndexPlus Total Return Inst PXTIX $14K 13 12 S&P 500 12000 lot of people’s minds is your research in fundamental indexing. It’s been very successful for you. Rob Arnott: Well, Fundamental Index is definitely a topic that has gotten immense play, and it has resonated in the marketplace The biggest shock in doing all of this research is that it wasn’t done decades ago. Imagine, if you will, that back in 1956 when Standard & Poor’s was getting set to launch the S&P 500 if there’d been somebody at the table saying: “Wait a minute. The companies in this index, based on its market capitalization, are going to wind up automatically, systematically, and irrevocably overweighting any companies that turn out to be overweight and underweighting any companies that turn out to be underweight. Why don’t we just weight companies by how big they are? Do it on sales. Do it on profits. Do it on book value.” If that conversation had happened, it’s easy to imagine that S&P would have said, “You know, let’s create an index that’s weighted on company size.” And if they had done that, the whole notion of capitalization weighting would have been nothing but a quaint, academically interesting concept. It would never have been embraced because it would have shown the underperformance that we see in our historical tests. People would have looked at it and said, “Sure, this is academically interesting, but why on earth do I want to use this?” KK: During the past decade, we’ve seen growth 05 06 07 Category Large Blend 7 Morningstar Rating Not Rated Minimum Investment $5 million Expense Ratio (%) 0.74 1-Yr Anl Total Rtn (%) 7.73 1-Yr Anl Investor Rtn (%)* 7.64 Investor Rtn Rank Category 28 Stewardship Grade X *Dollar-weighted return that measures how the typical investor in the fund fared. Data as of Dec. 31, 2007. . PowerShares FTSE RAFI US 1000 PRF Jul-05 Jul-06 Jul-07 $13K Aug-05Dec-05Apr-06Aug-06Dec-06Apr-07Aug-07Dec-07 Sep-05 Jan-06May-06Sep-06 Jan-07May-07Sep-07 Oct-05 Nov-05 Oct-06 Feb-07 Jun-07 Oct-07 Nov-06Mar-07 Nov-07 Feb-06 Jun-06 Mar-06 11 S&P 500 06 07 Category Large Value 1 Morningstar Rating Not Rated Data as of Dec. 31, 2007. Expense Ratio (%) 0.70 1-Yr Anl Total Rtn (%) 4.25 So, is Arnott just another performance chaser or is there more to his methodology than meets the eye? To find out, we caught up with him Oct. 30 in Las Vegas at the 2007 Schwab Impact conference and put him to the test, challenging some of the core assumptions that underlie his beliefs about index construction. This stocks—tech stocks in particular—grow to become a large share of the S&P 500 and then greatly contribute to the decline of the index. If you were to pull out that time period, what does your research show? RA: The two best years for Fundamental Index were, of course, the aftermath of the bubble as tech stocks were getting crushed, 2000 and 2001. The two worst years were the late stages of the bubble when tech stocks were soaring, 1998 and ‘99. Take out the two best and two worst years and what’s the average Jan-07 Jan-06 return over that span? Two percentage points betterMay-06 Sep-06Dec-06Mar-07Jun-07Sep-07Dec-07 Feb-06 than the S&P. Mar-06Jun-06 Oct-06 Apr-06 Jul-06 Nov-06 Aug-06 Apr-07 Jul-07 Oct-07 May-07 Aug-07 Nov-07 Feb-07 KK: Sounds like I’m talking to a value manager. MorningstarAdvisor.com 55

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Morningstar Advisor - Winter 2008

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