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This article explores the use of cap weighting and fundamental indexing as potential solutions to the pension problem. It highlights the drawbacks of cap weighting and presents fundamental indexing as a more efficient alternative. The growth and success of fundamental indexing in the US and Europe are also discussed.
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Does Cap-Weighting “Weigh us Down"?Converting part of the Pension Problem into part of the Pension Solution Robert D. Arnott / arnott@rallc.com Pensions & Investments December, 2006
Equities: Part of the Problem,or Part of the Solution • Liabilities have the Character of Long Strips and TIPS • Equities don’t. They create risk unrelated to the liabilities and take assets out of the markets that match liabilities. • Long Strips and TIPS produce a yield of 4-6% • Equities are used to reach for added returns. But, what if the risk premium is smaller than in the past. • Stocks are currently part of the pension problem • Stocks become an important part of the solution, if … • The return is far higher than bonds, and • The mismatch with liabilities is diminished.
Our Biggest Bets are in Equities – Can We Improve our Indexes?!
Problems with Cap Indexes • Introduces substantial growth bias • Fully participates in every market bubble • Fully participates in every market decline • Stocks selected by a committee (S&P, MSCI) • Or by formulas which are closely-guarded secrets • Most turnover is in the smallest names But the most important problem— • Over weights all over priced stocks • Under weights all under priced stocks
The Return Drag of Cap-Weighting • The Efficient Markets Hypothesis • Price identically equals true fair value for all assets at all times • Hardly anyone believes this • If price equals true fair value plus or minus an error … • Overvalued will have higher market capitalization and higher valuation multiples than they should • This creates the size and value effects • How likely is it that the top ten in market cap and the top ten in true fair value will be the same stocks? • Some of the top market cap get there through pricing error • None get there as a consequence of being undervalued!
Stocks at the Top Tend to Underperform Here’s where 20-25% of the index is invested … Source: Research Affiliates, LLC
Alternative Measures of Size • Main Street uses Fundamentals: • Income or Cash Flow • Sales or Revenues • Book Equity Value (Shareholders Equity) • Gross Dividends Paid • Creating an Index based on “Fundamentals” • An equity Index of 1000 stocks • Companies selected by fundamentals • Companies ranked by fundamentals • Companies weighted by fundamentals • This a Valuation-indifferent Index • Strips away linkage between portfolio weight and any over- or under-valuation
How Well Does the Fundamental Indexing Concept Work Outside of the US?(Japan Analysis Courtesy of Nomura Research Institute)
Fundamental Index™ Emerging Markets1987-2005 Cumulative Performance
Uses for a Fundamentals Index • Can serve as a broad market portfolio that replaces both value indexes and cap-weighted core indexes • Can replace active managers not likely to deliver 2.0% in net of fees value added • Can be a benchmark for active managers, freeing them from pressure to track an inferior cap-weighted index • Can provide a basis for a quantitative long/short portfolio • Can be a basis for a more efficient full market portfolio of international and/or global stocks
How is RAFI Growing in the US and Europe? • Current size is over $5 billion • Up six-fold from $800m at the start of the year. • FTSE has 12 licensees offering RAFI-based product • PIMCO adopted RAFI for enhanced indexing in 6/05 • Currently $600m assets • PowerShares launched ETF based on passive RAFI in 12/05 • Already over $800m assets, 3% value added with 99% correlation • Nomura has launched Kokusai and Japan portfolios in 11/05 & 2/06 • Over $300m assets; strong value added in both, in a bull market • CalPERS invested over $1B in 6/06; 1% added in 4 months • Expecting to launch EAFE portfolio this month • First European client was Nobel Foundation in 2/06 • Over 3% added in first eight months • Swedish National Pension (AP2) has over $1B invested • Handelsbanken launched first Pan-Europe ETF in 10/06 • Lyxor (largest European-Based ETF provider) plans Dec launch • Several other jumbo players, who prefer to remain anonymous, are planning large allocations before yearend.
Are We Blinded by Theory? • Theory does a Marvelous Job explaining how the world ought to work • Theories are sometimes provable, based on certain assumptions • Gaps between theory and reality are normal • Still, some observers cling to theory as fact • Assume a theory is correct description of reality • Assume that, therefore, the assumptions are correct • This is exactly backwards!
