Lawrence Jones: Hi! I'm Lawrence Jones Associate Director of Fund Analysis for Morningstar. And I have the pleasure today of speaking to Robert Arnott who is a Founder and Chairman of Research Affiliates and also manager of PIMCO All Asset and PIMCO All Asset All Authority., Robert, thank you very much for joining us.
Robert Arnott: It is really a privilege, thank you.
Lawrence Jones: Foreign investors that are less familiar with your fundamental indexing approach I’d be interested in having you’re talking them a little bit about your fundamental index products and how they—and you might have an advantage over market cap, traditional market cap waited in that.
Robert Arnott: Sure, fundamental index is actually a really, really simple idea. Let’s roll the clock back to when the S&P launched the, S&P 500 in the 1950’s. It was never launched as an investment vehicle. It was launched as an index to measure how the market was performing and if you want to measure how the market is performing you have the capitalization weight. You have to weigh companies by number of shares outstanding times price because that's what those companies are worth in the stock market. So, stock markets cap weighted the index should be. But let’s supposed there had been a co-merging on the new products committee who said “Well wait a minute, every company that's over valued were going to be overweighting, every company that's under valued were going to be underweighting isn’t that going to pull down our returns?” And besides this doesn’t resemble the overall economy anyway” it loads up on companies that are popular, trendy and expected to grow handily.
Why don’t we create an index that weights companies and selects them according to how big they are, what they're sales are, what they're profits are. If that had happened, it’s not impossible to imagine that that view might have carried the day because this was the era of Graham and Dodd and of John Burr Williams. An era in which people thought of investing in companies not investing in stocks. Well today, we’ve done a 180 degree about face, now we have a market centric view of the investing world people don’t think about the companies they're investing in.
But if your capitalization weight every company that’s trading above its fair value is above its fair value weight in the portfolio and because it’s above its fair value it will eventually under perform. So, you are inherently overweight companies that will under perform. What if you just create a portfolio that weights companies by some objective measure of the company size? Sales, profits, book value, dividends, this are all perfectly good objective measures, we like to use a blend of all four. But if you do that you're taking that link between price and weight and you’re breaking it.
You own a company based on how big it is, if the price gets ahead of the fundamentals you trim back, if it gets behind the fundamentals, you boost. So, what you have is a natural and objective anchor for rebalancing, for counter trading against the constantly shifting expectations, feds, bubbles and crashes of the stock market. And when we did this research we went back over 40 years in the US stock market and we found that you get about 2% higher return. Well, most active managers cant do that and this is just damn old index that doesn’t make any subjective decisions or evaluations of the company at all.
It was then tested all over the world and on average within individual countries that had historically adds about 2.7% and that's going back a full quarter century. You globalize it and now your counter trading against country bubbles and crashes. And so you wined up getting a little bit more about 3½%. You take it into small companies and you get a little bit more, you take it into the markets that were speculative pricing is most extreme, not stock or emerging markets. And you get even more. So we find that the value added seems to be very directly related to the magnitude of mispricing in the markets. It doesn’t mean that—every quarter or every year.
If you’ve got a growth dominated market where value is being punished, you will underperform but you will underperform in the context of owning a portfolio that is more and more deeply value at a time when values likely to be poised out perform. So, I think this is an idea that is likely to perform very nicely in the next three to five years.
Lawrence Jones: Thank you very much for joining us today.
Robert Arnott: Thank you for your time.
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