Sunday, December 03, 2006

Traditional Indexation, Fundamental indexation, and Market Spirits

Not exactly a subject that makes your socks roll up and down. Most value “guys” don’t give a moment’s thought to indexation...we believe that through application of our discipline, we can achieve superior results. But for those who want to buy portfolio “management” for the lowest possible cost, and who do not have the patience to accept the occasional poor relative performance of a disciplined value manager, I suggest that you look into index funds, but NOT traditional cap weighted index funds.

I am a proponent of active equity management as opposed to passive indexation. My view of “active” management does not imply anything about trading or momentum. It merely implies stock selection on an active basis rather than merely accepting a “laundry list” composed by an index committee.

Rex Sinquefield, a strong proponent of passive management, described passive management most clearly about ten years ago when he said:

“Passive management when applied to a client's entire portfolio is really asset class investing. This means investing literally in asset classes via passive portfolios that capture, in their entirety, the asset class or classes under consideration. For most asset classes there are long-time series of historical data that allow us to form reliable estimates of the risk of a given class and how closely the behavior of that class correlates with the behavior of other classes. An advisor can estimate the risk of different combinations of asset categories and find the overall portfolio strategy that best suits the circumstances and risk tolerance of his or her client.”

Many financial planners and brokers rely on this notion of equities behaving as a “class.” Projections of long term returns on an “asset class” rely on long term extrapolations of past history. The “Ibbotson-Sinquefield” numbers which describe the performance of various equity asset classes, based on market capitalizations are often used expectationally, anticipating that past performance is prologue.

The beauty of indexation is its low cost, which is a function of scale and low trading costs. Management fees are very low as a result of scale, and as a result of little “tampering” by professional portfolio managers, Research analytics and portfolio management skills are not called upon to follow a list, merely administrative adherence to a formulaic list, Regrettably, a large part of the actively managed “professionalism” is dissipated by non-disciplined, follow the leader behavior. Save for perhaps 10% of the actively managed profession (and I may be generous,) most investment managers subtract, rather than add to the performance by their actions. This has resulted to a lemming-like mindless embrace of traditional indexation as a solution to investment problems.

Traditional indexation based on “size” solely determined by market cap in my view is complete nonsense. Size, when defined by market cap really captures two effects, “size” as measured by book value, or earnings, or sales, multiplied by respectively, the Price to Book Value, the P/E, or the Price to Sales ratios. Consequently, market cap captures not just size but also what I best can describe as “Market Spirits.” Market Spirits is the desirability or the overall market’s assertion of how much it likes a particular other words, a “Value” effect, how the market values the security. Recognition of the incorrect measure of size that market cap suggests has led to what is known as fundamental indexation.

Rob Arnott, the very bright and talented editor of the Financial Analysts Journal, has written extensively about this topic. As he points out in an editorial in the Sept 2005 FAJ, Disentangling Size and Value, there are two ways to have a large market cap, either be a big company, or be a small company with a lofty valuation multiple, i.e. market spirits. He demonstrates that “value” effects are far more powerful than most people realize when “size” effects are appropriately measured.

In a paper published in March of 2005, Arnott ( with Hsu, and Moore) demonstrate that fundamentally constructed index portfolios outperformed their traditionally constructed market cap index analogs. The measures of “size” that were used consisted of:

• book value (Book),

• trailing five-year average cash flow (Cash Flow),

• trailing five-year average revenue (Revenue),

• trailing five-year average gross sales (Sales),

• trailing five-year average gross dividends (Dividends) and

• total employment (Employment)

Returns produced by fundamental indexes were on average about 2% higher per annum than that of the S&P 500 for the 43 year period that was measured in the study. Though that seems to many people to be a rather small incremental return, over time that increment amounts to substantial accumulated wealth. This resulted in an ending value for the period that was more than twice that of the S

How is this possible? What is the fundamental problem with market cap indexation? Very cap approaches tend to overweight the over-valued and underweight the under-valued securities. Having a heavy weighting in a portfolio of extremely expensive stocks is a sure way to wealth diminution and this is an unavoidable consequence of traditional indexation. Fundamental indexation relies on size measures that are not propelled and elevated by “market spirits,” irrational exuberance, etc.

Perhaps the difference in returns for the two approaches was already understood by Benjamin Graham many years ago. In the short run, the market is a voting machine, but in the long run, it is a weighing machine.

A early draft version of the Arnott, Hsu, and Moore paper can be accessed here.

There are several providers of fundamental index product. Rob Arnott’s firm Research Affiliates LLC has teamed with PowerShares and FTSE to produce the ETF which trades as PRF that focuses on the large size firms. Small to mid size firms can be accessed through PRFZ.

Sector portfolios using this approach have also recently appeared:

Basic Materials (PRFM), Consumer Goods (PRFG), Consumer Services (PRFS), Energy (PRFE), Financial Services (PRFF), Healthcare (PRFH), Industrials (PRFN), Telecom Tech (PRFQ) and finally Utilities (PRFU) are all available since September.

Pimco has also instituted a fundamental indexation product using Rob Arnott’s approach in its Pimco Fundamental IndexPLUS TR fund, PIXAX .This is a balanced fund that combines Pimco’s active fixed income style with a passive equity component that is fundamentally based.

WisdomTree employs a dividend based fundamental indexing methodology that weights companies based on the amount of cash dividends that is paid out. WisdomTree’s website features an excellent article first published in the Wall Street Journal in June of this year on the topic of fundamental indexation . The article, written by Jeremy Siegel of Wharton highlights the truism that the market prices of stocks may not always be the best estimate of the underlying value of the firm. He describes fundamental indexes as the next “wave” of investing.

Like PowerShares, WisdomTree offers numerous ETFs as well. The large ”Cap” dividend fund (DLN) the Total Dividend Fund (DTD) the Mid “Cap” Fund (DON) and the Small “Cap” Fund (DES) are the broad core funds that are available.

Sector funds are available from WisdomTree, however, they are international rather than domestic. I will have comments on International Indexing in my next post.

Please keep in mind that the net return that you realize from any of these approaches is dependent on the cost efficiency and scale of these ETFs. Being relatively small, they have yet to achieve the cost efficiency of the large index managers such as Vanguard. Consequently, their management expenses are considerably higher than that of managers such as Barclays iShares or Vanguard but below that of most actively managed funds.

Disclaimer: I am an investment manager who relies on disciplined stock-picking and portfolio construction to achieve returns. I, my family, and clients do not currently own any index funds mentioned in this post.


At 1:37 AM, Blogger Joe said...

Wisdomtree has recently released some even better products... earnings weighted indexes. From a value investor's perspective the very best appears to be EEZ which actually weights by earnings yield (inverse of P/E)! I think I might've found my ultimate no-brainer investment...


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