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The Fundamental Index: A Better Way to Invest | 
 enlarge | Authors: Robert D. Arnott, Jason C. Hsu, John M. West
Creator: Harry M. Markowitz
Publisher: Wiley
Category: Book
List Price: $29.95
Buy New: $14.66
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Avg. Customer Rating:  13 reviews
Sales Rank: 40141
Media: Hardcover
Number Of Items: 1
Pages: 336
Shipping Weight (lbs): 1.2
Dimensions (in): 9.1 x 6 x 1.3
ISBN: 047027784X
Dewey Decimal Number: 332.6
EAN: 9780470277843
ASIN: 047027784X
Publication Date: April 25, 2008
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Product Description
The Fundamental Index examines a new approach to indexing that can overcome the structural return drag created by traditional capitalization-based indexing strategies, and in so doing, enhance the performance of your portfolio. Throughout this book, Robert Arnott and his colleagues outline this breakthrough strategy and explain how it can be used to improve investment returns, typically at lower risk and lower cost than most conventional investments.
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| Customer Reviews: Read 8 more reviews...
 An interesting quant approach to portfolio investing August 14, 2008
The authors describe in detail how the RAFI index methology works and answer also many critisism to their approach. What is still missing is a significant real track record (they mix proforma and actual results, unfortunately). It also shows clearly the shortcomings of the current marketcapweighted indices. In short: Very important subject but maybe too many pages for one idea.
Value based investing with a new name July 28, 2008
2 out of 2 found this review helpful
Arnott claims his fundamental index historically gives a 2% improvement in return compared to conventional cap-weighted indexes [page 263 from 1962-2007 with S&P 500 with a return of 10.3% and sigma of 14.6%.........and his RAFI U.S. Large with a 12.3% return and sigma of 14.4%]. Arnott also says the RAFI returns shown in the appendix are before expense ratios are applied [p. 262]. Some RAFI funds have expense ratios of 0.75%. If you assume a typical Vanguard conventional mutual fund ER of 0.2%, then the fundamental index advantage in U.S. large caps falls from 2% to 1.65% [S&P 500 return of 10.3% - Vanguard ER of 0.2% = 10.1%........and RAFI return of 12.3% - ER of 0.75% = 11.55%.......gives a 1.45% advantage to RAFI]
Many critics of Arnott claim his fundamental index is really just a value tilt and investors could achieve the same value tilt with typical Vanguard low 0.2% ERs versus Arnott's high 0.75% ERs (of course Arnott would not get rich from his cut of the 0.75% ER if investors just value tilted using Vanguard funds).
The only historical returns data set I have available to me runs from 1972 to 2007. I calculated the historical returns from 1972 to 2007 assuming actual Vanguard expense ratios and the RAFI index having a 0.75% ER. I got the annual RAFI U.S. Large returns before expense ratio fees from the appendix of Arnott's book. I got the Vanguard fund returns from the Excel sheet referenced on the Bogleheads web site [Bogleheads dot org].
Fund Name...................Symbol..............1972-2007 CAGR...RAFI comparison
RAFI U.S. Large.............n/a...................12.88%
Vanguard Index 500........VFINX...............10.91%.......1.97% less than RAFI
Vanguard Large Cap Value...VIVAX...........12.94%......0.06% more than RAFI
Vanguard Small Cap Value....VISVX..........14.15%......1.27% more than RAFI
Arnott only provides data in his book on his RAFI international from 1984 to 2007. Comparing RAFI international to Vanguard's international value fund gives:
Fund Name...................Symbol..............1984-2007 CAGR...RAFI comparison
RAFI International..........n/a...................14.09%
Vanguard Intern'l Value....VITRIX............13.82%....0.27% less than RAFI
From this historical returns data, it appears the pundits of Arnott's theory are correct: Ordinary investors could achieve the same results as Arnott's fundamental indexes by simply tilting their portfolios towards value index funds.
Arnott claims the largest return advantage using fundamental indexing occurs in emerging markets.....with a 10.7% advantage from 1994-2007 [page 281]. Unfortunately, Vanguard does not offer an emerging markets value fund to compare to Arnott's RAFI index.
One could speculate on how to come up with a snazzy new index in which you could collect a licensing fee for use of the index...using the following questions and answers:
Q: What determines the return of stocks?
A: Fama and French showed that returns are a function of style (value versus growth) and size (small versus large)
Q: How could we create our snazzy new index based upon F&F's work that showed that value stocks have higher returns than growth stocks?
A: We could base our snazzy new index on typical value indicators of company....like dividends, sales, cash flow, book value.
Q: These 4 typical value indicators are not very exciting and are well known...with book value dating back to the 1930's with Benjamin Graham. How could we make this sound more exciting to the average investor?
A: We call these 4 typical value indicators Main Street versus Wall Street indicators.....this will appeal to the average Joe.
Using the above Q & A's as a line of thought........we now have a snazzy new index name called Fundamental Indexing and an appealing story of using Main Street versus Wall Street indicators to rank the stocks in the fund. We can claim the idea is revolutionary and we are therefore justified in charging high expense ratios to use the new index.
The one RAFI index that might be attractive to ordinary investors is his Emerging Markets index. Historical data has shown a 10.7% advantage over conventional emerging markets index funds. Vanguard does not offer an emerging markets value fund, so this asset class is not easily accessible to investors. DFA does offer an emerging markets value fund, but you can only buy them through a DFA advisor with a typical 1% fee. The relatively high 0.85% ER for the Powershares PXH fund might be worth it to try to capture some of the 10.7% return given there are no other ways to easily invest in this asset class.
Over-all, this book is easy to read. Time will tell if Arnott's fundamental indexes outperform value based cap-weighted index funds net of expenses.
Other books which are based upon traditional cap-weighted index fund investing are shown below:
Index Mutual Funds: How to Simplify Your Financial Life and Beat the Pro's
The Richest Man in Babylon
Bogle on Mutual Funds: New Perspectives for the Intelligent Investor
The Millionaire Next Door
The Four Pillars of Investing: Lessons for Building a Winning Portfolio
A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, Ninth Edition
The Coffeehouse Investor: How to Build Wealth, Ignore Wall Street, and Get On With Your Life
The Bogleheads' Guide to Investing
 Past performance is no guarantee of future one July 20, 2008
6 out of 6 found this review helpful
This book written by the strongest advocate practitioner (Arnott) of Fundamental Indexing (FI) is well written. But, you should not confuse a FI manifesto for a balanced analysis on FI vs Market Cap Indexing (MCI). Arnott goes as far as stating that FI has redefined the entire investment Efficiency Frontier (pg. 241) as for any level of risk, he believes FI earns a higher return. And, for any level of return FI reduces your risk. To his credit, Arnott does a good job of addressing the main critiques against FI in chapters 10 and 11. However, for more challenging FI rebuttals, I recommend the articles by Paul Kaplan and Andre Perold.
The logical advantage of FI is unclear. In the Foreword, Harry Markowitz makes an example with a two stock portfolio and shows how stock mispricing will cause MCI to be over weighted in the overpriced stock. When such a stock reverts back to its fair value, MCI suffers a return drag vs FI. But, Andre Perold using Bayesian analysis, takes apart this exact same example because you don't know beforehand which stock is over valued. To further confuse things, Arnott early in the book (page 38) contradicts himself. He states that a MC index does not have a negative Alpha. But, capitalization weighting does. That's not possible. Either they both incur negative Alpha, or they don't (besides the minor cost difference). Later, on page 208 according to his own analysis, Arnott recognizes that with large caps only 1/3 of the FI value added comes from its actual structure. The other 2/3 come from small cap and value tilts.
To clarify this issue, I will review: a) what I expect the difference between FI and MCI to be, b) the historical records, and c) the FI outlook.
Because FI is under weighing growth stocks, I expect it outperforms during Bear markets and underperforms during Bull markets. Because Bull markets are much longer than Bear ones, I expect FI to earn lower returns but with lower volatility. On a risk-adjusted basis the two should earn equivalent returns. When factoring FI higher turnover resulting in higher operating costs and taxes, MCI should come out slightly ahead.
FI historical back tested records are very impressive. Contrary to my expectation, over the 1962 to 2007 period FI outperformed MCI in Bull markets (by a small margin). And it killed MCI by several percentage points in Bear markets. Overall, FI beats MCI by 2 percentage points p.a. (for large cap) while incurring the same risk (same standard deviation). FI beats the MCI for just about any segment of the equities market: large cap, small cap, value, growth, international, country specific (pg. 123), emerging markets, and REIT. The FI advantage increases from 2% to up to 6% as you move into less efficient markets such as emerging markets. Such historical results are not entirely explained simply by FI smaller cap and value tilt. Any higher return is usually associated with much higher risk (but not for FI). Also, FI beats MCI when focusing on either value or small cap stocks only. Thus, something is going on besides small cap value tilt. Arnott states FI superiority is due to the inefficient allocation of MCI that overweighs the growth stocks that suffer the worst returns in Bear markets. But, FI under weights this same growth stocks during Bull markets. What the FI gains during Bear markets, it should give back during Bull markets. But, it did not. It beat the MCI during Bull markets too. The few times the FI fell behind is during short bubbles such as the late 90s dot.com bubble.
Actual live performance of FI funds has been so far not impressive. This contradicts the author's assertion on page 176. That's because my data set extends another 7 months since the book was published. I investigated the two RAFI funds with available public records: RAFI US 1000 (PRF) covering large caps started in December 2005 and RAFI US 1500 (PRFZ) covering smaller firms. The funds history is short, but is a good test as it captures a Bear Market that started in May 2007. Thus, I would expect the RAFI funds to do better than their MC index fund counterparts. I compared PRF and PRFZ with the traditional index funds most correlated with them, respectively Vanguard Large Cap Value (VIVAX) and Vanguard Small Cap Value Index (VISVX). Since inception the RAFI funds have earned the same return (essentially zero) while incurring the same volatility vs their traditional index counterparts. Since May 2007 (beginning of Bear Market), PRF return is - 23.1% vs - 22.7% for VIVAX. (PRF did a bit worst than VIVAX). Meanwhile PRFZ return is - 20.3% vs - 21.9% for VISVX. (PRFZ did better than VISVX). In both cases, those RAFI funds way underperformed a plain total stock market index fund, especially in a Bear market. This short term track record, especially in a Bear market that should favor RAFI funds, does not give you confidence that such funds will duplicate the impressive historical back tested record.
Paul Kaplan suggests already the next step: MCI with boundaries delineated by certain multiple of fundamentals. He calls this a collared index. When a specific stock would bubble its weight within the portfolio would be reduced by the delineated fundamentals boundaries. By doing so you would preserve the advantages of MCI (low cost, diversification) while avoiding excessive concentration in over heating stocks (FI advantage). I hope Kaplan puts this concept into practice.
If you find this book interesting, I recommend the following books that also defy existing investment theory: Market Volatility, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, and The Misbehavior of Markets: A Fractal View of Risk, Ruin & Reward. If you want to better understand what traditional investment indexing is about, I recommend the classic A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, Ninth Edition.
Fundamental Indexing is Active Management, Not Indexing July 1, 2008
First of all, a market portfolio is holding capitalization-weighted stocks. So when Arnott says his "fundamental indexing" beats a cap-weighted portfolio (like on p. 160), he's simply making the same argument active managers make when they say they can beat the market.
It's important to note too that a fundamental index is only a fundamental index once per quarter. These things don't rebalance daily, folks. Even with quarterly rebalancing though, the turnover is higher than with cap-weighted index funds or ETFs. So that's one cost that fundamental indexing must overcome.
The other thing to point out is merely with the fact that more oversight and work is required on the part of the fund company, the expense ratio will be higher than a completely passive cap-weighted index fund. Are the higher fees worth the bet you're making on this strategy?
If markets are truly efficient, then cap weighting is the way to get the market rate of return. Anything else is almost by definition an active or quant (which is what fundamental indexing is) bet.
Your best bet as an investor is to skip the hype and go for the market rate of return.
With all that said, I do still recommend this book to further your investment education. I give it 4 stars out of 5.
 Simple, yet powerful - or Simple, thus powerful? June 30, 2008
1 out of 2 found this review helpful
I believe the book is a must read for professional investors as well as non-professionals, advisors, trustees and most certainly the academic community. It offers a (deceptively) simple explanation to a series of widely debated issues in modern portfolio construction. While I wouldn't dare entering into a debate with any of the rather well-known critics of the concepts I would propose that they all read the book carefully and contemplate the principle known as Occam's razor while doing so; "Occam's razor (sometimes spelled Ockham's razor) is a principle attributed to the 14th-century English logician and Franciscan friar William of Ockham. The principle states that the explanation of any phenomenon should make as few assumptions as possible, eliminating those that make no difference in the observable predictions of the explanatory hypothesis or theory." (Quote from Wikipedia) The Fundamental Index concept as such may not be new, other will have to be the judge of that, but at least I know of no other formalization of the concept, nor of any other text offering the richness in its explanations of the sources and applications of the concept. (Disclosure: I am on record as being a supporter of the concept and I work for a firm that is a Research Affiliates, LLC, licensee.)
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