In an interview with Bloomberg View’s Barry Ritholtz, Research Affiliates’ Rob Arnott recently talked about the fundamental indexing approach that he pioneered.
Arnott discusses the big flaw in traditional indices, which weight their components using market capitalization. That means that when a stock gets overvalued, it makes up more of a portion of the index than its fundamentals merit. So just when an overvalued stock comes back to earth, Arnott says, that’s when you own the most of it.
Instead, Arnott weights index components using companies’ economic attributes — sales, dividends, profits, and book value. His research shows that such an approach adds 2 percentage points per year vs. market-cap-weighted indices over the long term. He also talks about how his research shows that using just one economic metric to weight an index has resulted in that 2 percentage point outperformance; using additional variables smooths returns, but doesn’t increase them overall.
Arnott also says that Wall Streeters often overlook simple mathematical concepts, to their detriment — they ignore the fact that when stocks go down, expected returns go up, and vice versa, for example. Disciplined, rational investors can take advantage of that, he says. Investors are also overestimating future returns, he says, which should roughly be equal to dividend yield plus growth in profits and dividends. A reasonable expectation, he says: 6% (2% dividend yield plus 4% profit and dividend growth). That subpar 6% figure has led him to look to alternative assets, many of which investors ignore, he says