The one thing we know about panic sell-offs is that they always create opportunities for bargain-hunters with extended time horizons.

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It might seem perverse, after a week when global stock markets slipped into panic mode, to consider the merits of a new way of calibrating the market’s performance that can realistically only prove its value over the longer term. The one thing we know about panic sell-offs however is that they always create opportunities for bargain-hunters with extended time horizons. Last week’s events, we can be sure, will prove be no exception, which is one reason, no doubt, why Warren Buffett has been dipping into his cash pile to pick up shares in Swiss Re and a mixed bag of other instruments on the cheap.

In Japan, meanwhile, according to one report last week, more than half the listed companies in Tokyo are now trading below book value. The earnings yield is above the bond yield, typically a bullish signal, and more than 140 companies are valued at less than the cash on their balance sheets. Yet the Japanese market still got hammered along with the rest of the world. Mr Market is clearly not at his most coherent, as he rarely is at times of market stress.

A new bear market, if that is where we are heading, could prove to give a useful boost to the new fundamental index instruments now being brought to market. Until now I have been somewhat sceptical about these variants on traditional passively managed instruments. Despite the impressive academic qualifications of some of their leading exponents, such as Wharton’s Jeremy Siegel , the suspicion is that fundamental indices are little more than a classic example of data mining.

They clearly back test well, but that, we know, is rarely a precondition, let alone a guarantee, of future success in investment. Are the superior long term results that fundamental indices display in the laboratory anything more than a reflection of the value effect that is already well-documented in finance literature? That is the argument which Gus Sauter, the chief investment officer of Vanguard, for example, uses to counter the competitive threat that fundamental indices pose to its conventional indexing model. 

However a recent meeting with Rob Arnott, the chairman of Research Affiliates, and former editor of the Financial Analysts Journal, has prompted me to think again. The concept of fundamental indexing, it turns out, is far more subtle and radical in its application than I had appreciated. If the claims for fundamental indexing continue to be borne out in practice, it will strike some powerful blows at the prevailing orthodoxy of how funds are managed and performance assessed.

Mr Arnott’s argument goes something like this. Capitalisation-weighted indices such as the S&P 500, against which investment managers are traditionally measured, are the child of conventional financial theory. They are based on the premise that market prices are the best estimate of fair value that investors are likely to find. This in turn is the fragile rock on which the CAPM and the efficient markets hypothesis, among other textbook constructs, rest.

However, as everyone knows, the theory is a poor approximation of reality. Mr Arnott’s point, in essence, is that cap-weighted indices are inherently flawed as a proxy for the market portfolio. Not only do they reflect the market’s inability to discount the future correctly, but the errors that the market makes in its assessment of fair value are asymmetric. By definition they have an in-built style bias, away from value and towards growth. If market capitalisation is your primary metric, it will automatically overweight overvalued stocks and underweight undervalued stocks.

The errors in pricing, in other words, are all one way. Undervalued shares are by definition more likely to drop out of cap-weighted indices than climb into them, which is why the 10 largest stocks in the S&P 500 have consistently underperformed the average stock in the same index over time (in seven years out of ten, on Mr Arnott’s calculations, over the 80 years to 2006). These biases may in fact be the primary source of the size and value effects that academic research into cap-weighted performance history has documented.

What the successful back-testing of fundamental indices really shows, in Mr Arnott’s view therefore, is how much value is subtracted from the market’s fundamental return by funds (including conventional index funds) whose performance is measured against flawed cap-weighted indices. The way that fundamental indices are constructed is more closely tied to real world measures of corporate success, such as sales, dividends and size. As a result they are a less imperfect proxy for the market portfolio.

If you accept this view, it has far-reaching and intriguing implications. One is that fundamental indexing may actually be a superior form of passive investment; it has a theoretical justification, not just data mining support.  The second is that it opens a nice potential arbitrage opportunity for active fund managers. Why not simply track the fundamental indices and label the outcome as active management, with fees to match? At least one fund management company has done just that.

On Mr Arnott’s statistics, the long run advantage of fundamental over conventional indexing approaches 200 basis points per annum, with similar volatility and therefore a superior Sharpe Ratio. Over active fund managers, the majority of whom underperform their cap-weighted benchmarks, the edge is proportionately greater.

Mind you, even if you accept these arguments, it has taken 30 years for conventional indexing to capture what is still a minority share of the global fund management business.   Any progress that the new fundamental index products make is likely to be equally glacial, given the strength of vested interest that is embedded in incumbent asset managers of all types (both active and passive).

But as the evidence appears to be that the superior performance of fundamental over cap-weighted indices rises in proportion to the bearishness of markets, they may well find tailwinds on their side in today’s tricky, stagflation-worried market conditions.



Jonathan Davis
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