How do you spot a portfolio innovation that works? Rob Arnott, best known for developing the fundamental indexing approach to portfolio management, has almost $100 billion pointing in his direction.
Arnott, winner of this year's Portfolio Innovator Influencer Award, founded Research Affiliates in 2002 to create a set of index methodologies that are licensed to indexing giants like FTSE and Russell. The investment products based on Arnott's fundamental indexes - and managed by firms like PowerShares, PIMCO, and Charles Schwab - now account for roughly $98 billion in assets.
Arnott's strategy is based on the notion that markets aren't always efficient. He points to both the tech and financial bubbles as examples of where market capitalization grossly overvalued stocks. As Arnott explains it, fundamental index construction breaks the link between price and the weight in the portfolio.
While traditional indexing weights stocks according to market capitalization, Arnott's fundamental indexes - now known as RAFI indexes (for Research Affiliates Fundamental Indexing) - weight stocks according to different measures: cash flow, sales, dividends and book value.
Arnott argues that market inefficiencies can lead to a 2% annual drag on returns, compared with the fundamentally indexed counterparts, which work to exploit these market inefficiencies.
Charles Schwab just announced six new fundamental indexes using Russell RAFI indexes. "Arnott is the pioneer and innovator of the new wave of smart beta strategies," says Anthony Davidow of the Schwab Center for Financial Research. "His work is an evolutionary step forward and benefits advisors and investors."
Fundamental indexing is not without its critics. Prominent advisor Rick Ferri of Portfolio Solutions argues that the fundamental indexing approach overweights two additional factors that Eugene Fama and Ken French quantified decades ago. (The Fama-French three-factor model asserts that beta, size and value tilts are determinants of performance.)
Although Dimensional Fund Advisors has been tilting portfolios toward small cap and value factors since 1981, Ferri gives credit to Arnott for bringing this type of factor investing to the public directly, since DFA funds are generally purchased through advisors only.
Arnott agrees that his strategy has a small cap and value bent. He does claim, however, that the fundamental index captures all three Fama-French factors more efficiently than any other commercially available benchmark or product.
And Davidow argues that Arnott's research on fundamental indexing goes beyond the work conducted by Fama-French.
Some believe Arnott has developed better indexing, while others feel he has developed a marketing innovation around "smart beta." Neither camp, however, can deny that Arnott's portfolio innovation is a unique and innovative indexing methodology that has quickly gained marketplace acceptance.
- Allan S. Roth