Fundamental Index Funds

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Fundamental Index Funds

Postby bUU » Mon Mar 25, 2013 6:05 am

I read this article this morning, which seems to indicate that this is "new"... that "now" there's this new kind of mutual fund....

Next big thing: equal-weight index funds

So I came here to see if folks were discussing it, and found threads about it only back in 2007-2011. The Wiki has what I suspect is a rather dated comparison of traditional index fund returns against comparable fundamental index fund returns, and to old threads. It seems to me that, given the passive, data-based means of building such indices, that there should have been, and now should be, a very easy way of reconstructing what such funds would have looked like, going back thirty years, so a reasonable comparison can be made. Does anyone know of such a comparison? Do folks have new perspectives on such index funds, a few years after the last discussion about it that I could find?
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Re: Fundamental Index Funds

Postby nisiprius » Mon Mar 25, 2013 9:32 am

No data, sorry. but it is perhaps worth mentioning that the first attempt to create an index fund was an equally weighted fund.
From The Myth of the Rational Market by Justin Fox. My boldface:
In 1971 the courts definitively closed the door to a Wells Fargo retail mutual fund. The Wells team was wondering what to do next when a recent Chicago graduate, whose family owned luggage maker Samsonite, came calling. Inspired by what he'd learned in class, the young man had persuaded his elders to invest some of the company's pension money in an index. When he asked his Chicago professors who might be willing to manage such an index fund, they steered him to Wells Fargo. Managing institutional funds wasn't against the Glass-Steagall rules, so the Wells crew put Samsonite's $6 million into every stock on the New York Stock Exchange, with an equal amount of money in each stock. The idea had been that an equal-weighted fund might outperform the straight index, but it soon became clear that keeping the weights equal required so much trading that the fund wasn't nearly as low-cost as envisioned. After several years of trial and error, Wells set up an S&P 500 fund for pension funds and other big institutional investors that held stocks according to their weight in the index. By the time the fund launched, though, Wells had two competitors: American National Bank in Chicago, where 1972 Chicago MBA Rex Sinquefield was the driving force, and Batterymarch, an upstart Boston firm that had been pushing the index idea since 1971 but didn't land its first customers until 1974.
David G. Booth and Rex Sinquefield went on to found DFA.

My knee-jerk prejudices--1) equal weight just seems goofy to me. I cannot see why it makes any more sense than, say, "alphabetical weight" (devoting 1/351 of portfolio to ticker symbols beginning with "A", 2/351 to "B", ... 26/351 to "Z". That historically has either outperformed or underperformed the S&P. If it outperformed, launch it. If it underperformed, then use reverse alphabetical weighting and launch it).

2) Between Vanguard and many others, including both mutual funds and ETFs, there are plenty of cap-weighted index funds, so there's not much room in that market, and obviously the only way to compete with them is to introduce new wrinkles and variations--"it's just like an index fund, only better." There has been a lot of this in the last few years. For example, does anyone but me remember Fidelity's "Enhanced Index Funds?" I would maintain what I'll call "Bayesian skepticism," i.e. allow for the likelihood that such products will be overmarketed and that you will hear more about them than their merits might warrant.
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Re: Fundamental Index Funds

Postby pkcrafter » Tue Mar 26, 2013 1:42 am

Here's a thread from earlier this month...

http://www.bogleheads.org/forum/viewtopic.php?f=1&t=112488&newpost=1637542

If fundamental or equal-weighted indexing become the favored way to invest, total stock market index will eventually track it! At least the cap-weighted total market index tracks the consensus of where all investors put their money, whereas an equal weighted index has no reason at all to be equal weighted. Fundamental indexing has some rationale behind it, so it's a better choice than EW indexing.

For a long time I didn't know if these index funds should be classified as index funds or active funds, but they do posses some main advantages of indexing such as consistency, and they are fee from manager tinkering, which is a plus in my opinion.


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Re: Fundamental Index Funds

Postby ClosetIndexer » Tue Mar 26, 2013 3:06 am

ISTM that both equally and fundamentally weighted portfolios are simply ways to achieve small and/or value tilts. Equal weighting is obviously a very simplistic way, but if that results in reduced costs, it's conceivable it could be an efficient one. That said, I can't see it outperforming a more intentional small-weighted portfolio that was designed to minimize turnover. Fundamental weighting is perhaps better, and early evidence suggests that it does a good job of capturing some of the small and value premiums with minimal negative alpha. Again, nothing 'fundamentally' new (heh), but perhaps an efficient new(ish) take on an older concept.
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Re: Fundamental Index Funds

Postby larryswedroe » Tue Mar 26, 2013 8:46 am

First, even Arnott I believe has admitted that there is nothing special about his RAFI indices, they are nothing more than size and value tilts whose returns are explained well by factor models
Here is a post I wrote on the subject http://www.cbsnews.com/8301-505123_162-37843058/are-fundamentally-weighted-indexes-a-better-mousetrap


Second, you might read this piece to show how serendipity can play a role in returns

http://www.cbsnews.com/8301-505123_162-37842052/how-serendipity-plays-a-role-in-returns/


Hope these help
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Re: Fundamental Index Funds

Postby EDN » Tue Mar 26, 2013 12:02 pm

By the way, in my book, these RAFI fundamental indexes are active strategies. Don't let the "index" in the name fool you. Their exposure to growth/value waxes and wanes over time based on their weighting of stocks by their "economic footprint". Making portfolio changes (or your funds doing it for you) based on valuations is always an active decision.

This differs, of course, from investors who hold value or small stocks in greater than market proportions on a permanent basis, or fixed income investors who hold longer-term or lower-quality bonds in pursuit of higher returns.. They are just trying to capture/increase their exposure to separate risk/return dimensions, and so long as they do so statically and permanently (until personal circumstances change), that's a passive approach. It's not an old-school passive approach -- that being the view that only your stock/bond mix matters, but it's passive none-the-less.

Now, if you are going to invest actively, the fundamental indexes would probably be better than most due to an awareness of small/large and value/growth behaviors and low costs.

Eric

edited: to clarify which fundamental indexes I was referring to
Last edited by EDN on Tue Mar 26, 2013 2:02 pm, edited 1 time in total.
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Re: Fundamental Index Funds

Postby larryswedroe » Tue Mar 26, 2013 1:13 pm

Eric
On this one we'll just disagree, IMO it's simply a different way of defining value, instead of market cap weighting. The results are the same basically. One difference between them and say DFA and Bridgeway is that like most index funds use annual reconstitution (instead of say monthly) which leads to more style drift as stocks migrate out, so they lose some exposure to the factors over the course of the year. But IMO that's about it. Certainly no fundamental or technical analysis going on, no overriding of screens, which to me is what differentiates active management, not a non market cap weighting
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Re: Fundamental Index Funds

Postby EDN » Tue Mar 26, 2013 2:08 pm

larryswedroe wrote:Eric
On this one we'll just disagree, IMO it's simply a different way of defining value, instead of market cap weighting. The results are the same basically. One difference between them and say DFA and Bridgeway is that like most index funds use annual reconstitution (instead of say monthly) which leads to more style drift as stocks migrate out, so they lose some exposure to the factors over the course of the year. But IMO that's about it. Certainly no fundamental or technical analysis going on, no overriding of screens, which to me is what differentiates active management, not a non market cap weighting
Larry


Larry,

Actually, I think we agree, I just wasn't clear in my post above, which I've edited. If you weight by dividend, book value, equal weight, or whatever...that's passive--as long as you aren't jumping back and forth. If your weightings change over time (as RAFIs do) based on a perception of mispricing (saying you know something the market doesn't), then that's active.

There is no magic in cap weighting, it produces the least turnover and the lowest costs, but simultaneously concentrates holdings in the biggest and most economically healthy companies (LG) when applied to the entire market. That was fine when we believed all stocks were basically the same, and when commissions and bid/ask spreads were prohibitively high, but today asset pricing research tells us we should care about more than just the stock/bond distinction, and markets are deep and liquid enough, and portfolio managers can be patient and thoughtful enough to minimize (or even reverse) costs associated with non-cap weighting. All in an effort to create a more complete and customized investment portfolio.

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Re: Fundamental Index Funds

Postby larryswedroe » Tue Mar 26, 2013 2:30 pm

Eric
I dont' think we agree here.

I think we both agree that if RAFI market cap weighted based on the four metrics (instead of just one as DFA does) then we would both say that's passive, just a different way of determining value

Where I think we disagree is that you think that because they don't market cap weight but using a different method, then it's active, and I don't any more than say if one decided to equal weight instead of market weight would be active.

Now we do agree that fund construction rules matter in OUTCOMES because strategies have no costs but implementing them does. But whether you reconstitute monthly or annually (which causes the drift I believe) should not determine if one is active or passive, or even if you weight by "economic footprint" instead of market cap. The differences in construction can make a fund a good or bad choice but not whether one is active or passive.

Just my opinion, or how I look at things.

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Re: Fundamental Index Funds

Postby EDN » Tue Mar 26, 2013 2:41 pm

larryswedroe wrote:Eric
I dont' think we agree here.

I think we both agree that if RAFI market cap weighted based on the four metrics (instead of just one as DFA does) then we would both say that's passive, just a different way of determining value

Where I think we disagree is that you think that because they don't market cap weight but using a different method, then it's active, and I don't any more than say if one decided to equal weight instead of market weight would be active.

Now we do agree that fund construction rules matter in OUTCOMES because strategies have no costs but implementing them does. But whether you reconstitute monthly or annually (which causes the drift I believe) should not determine if one is active or passive, or even if you weight by "economic footprint" instead of market cap. The differences in construction can make a fund a good or bad choice but not whether one is active or passive.

Just my opinion, or how I look at things.

Larry


No,

Where I think they are active is in how they change the weighting of companies based on their beliefs of mispricings.

From their website on whether prices are right or wrong:

Markets are not always efficient

Look at stock prices during the Tech Stock Bubble of the late 1990s and its subsequent deflation and the nightmarish collapse of banking stocks during the Global Financial Crisis. Capitalization-weighted equity indexes incorporate these inefficiencies, overweighting overpriced stocks and underweighting undervalued stocks. These inefficiencies lead to a drag on returns of about 2% a year in developed markets and more in less efficient markets, according to our research.


This is old-school broker/active management speak. Some stocks are "overvalued", some are "undervalued", etc.

On implementation and whether they are just value/growth portfolios, or something else...

Dynamic value and size tilts

Fundamental Index strategies have a value tilt and a slight small-cap tilt. These tilts, however, are dynamic: When value stocks are out of favor and thus are cheap, Fundamental Index strategies tend to increase their allocation to deep value stocks. This phenomenon was vividly displayed in March 2009 when financial, industrial and consumer discretionary stocks were priced at bargain-basement levels. When value is in favor, the value tilt is much milder because these stocks tend to be priced higher. Rebalancing into unloved stocks and out of the most popular stocks—which we call "contra trading"—provides the majority of RAFI strategies' added value.


So they only hold value stocks when they are poised to outperform, and avoid them when they aren't. They say the value in their approach isn't from exposure to priced sources of risk/expected return, but their ability to time these return dimensions.

Thats active!

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Re: Fundamental Index Funds

Postby ClosetIndexer » Tue Mar 26, 2013 3:13 pm

EDN wrote:On implementation and whether they are just value/growth portfolios, or something else...

Dynamic value and size tilts

Fundamental Index strategies have a value tilt and a slight small-cap tilt. These tilts, however, are dynamic: When value stocks are out of favor and thus are cheap, Fundamental Index strategies tend to increase their allocation to deep value stocks. This phenomenon was vividly displayed in March 2009 when financial, industrial and consumer discretionary stocks were priced at bargain-basement levels. When value is in favor, the value tilt is much milder because these stocks tend to be priced higher. Rebalancing into unloved stocks and out of the most popular stocks—which we call "contra trading"—provides the majority of RAFI strategies' added value.


So they only hold value stocks when they are poised to outperform, and avoid them when they aren't. They say the value in their approach isn't from exposure to priced sources of risk/expected return, but their ability to time these return dimensions.

Thats active!


I'd have to disagree. It's not active, because it's formulaic. They don't make active determinations at any given time, but rather simply follow their pre-determined weighting strategy. They believe that the resulting dynamic degree of tilt is what provides the funds' outperformance. I disagree, aside from one significant lucky rebalance timing. (Although it might be related to how they've kept negative alpha relatively low. Time will tell.) But either way, it's not active management.

I could see a case that while it is passive, it's not indexing. But honestly I feel like we're getting into semantics at that point.
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Re: Fundamental Index Funds

Postby larryswedroe » Tue Mar 26, 2013 3:28 pm

Eric
Perhaps this is the problem

Arnott IMO concocted this idea about mispricings leading to his method which supposedly solved that problem. The whole concept is nonsense because it's certainly possible that even if the mispricing idea is right it could be the smallest companies that are the most mispriced, not the largest. We now that the whole fundamental indexing is nothing more than a value strategy and size strategy, that's it. There is no mispricing story. They don't shift things based on any opinions, it's all formulaic just like it is for ranking by market cap

I hope that is helpful

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Re: Fundamental Index Funds

Postby EDN » Tue Mar 26, 2013 3:29 pm

ClosetIndexer wrote:
EDN wrote:On implementation and whether they are just value/growth portfolios, or something else...

Dynamic value and size tilts

Fundamental Index strategies have a value tilt and a slight small-cap tilt. These tilts, however, are dynamic: When value stocks are out of favor and thus are cheap, Fundamental Index strategies tend to increase their allocation to deep value stocks. This phenomenon was vividly displayed in March 2009 when financial, industrial and consumer discretionary stocks were priced at bargain-basement levels. When value is in favor, the value tilt is much milder because these stocks tend to be priced higher. Rebalancing into unloved stocks and out of the most popular stocks—which we call "contra trading"—provides the majority of RAFI strategies' added value.


So they only hold value stocks when they are poised to outperform, and avoid them when they aren't. They say the value in their approach isn't from exposure to priced sources of risk/expected return, but their ability to time these return dimensions.

Thats active!


I'd have to disagree. It's not active, because it's formulaic. They don't make active determinations at any given time, but rather simply follow their pre-determined weighting strategy. They believe that the resulting dynamic degree of tilt is what provides the funds' outperformance. I disagree, aside from one significant lucky rebalance timing. (Although it might be related to how they've kept negative alpha relatively low. Time will tell.) But either way, it's not active management.

I could see a case that while it is passive, it's not indexing. But honestly I feel like we're getting into semantics at that point.


Closet,

All (or most) investment approaches have a formula. But is the formula attempting to provide constant exposure to some section of the market or to the market itself in cap-weighted or some re-weighted configuration, or are they trying to juxtapose that exposure based on perception of mispricing or under/over valued conditions?

Value funds have a formula: buy the cheapest 20% of stocks ranked by price to book (for example). When value/growth spreads are wide, the parameters stay the same--bottom 20%. When the spreads are narrow, the parameters stay the same--bottom 20%. Investors in these funds don't change their holdings, just their expectations With RAFI, the holdings and the weightings can change dramatically based on their quantitative analysis of relative prices. Could be a growth fund one day, a value fund the next...and attempt to exploit/avoid better or worse risk adjusted returns based on market conditions, not continual exposure to the sources of priced risk.

It's really no different than Vanguard running a 60/40 balanced stock/bond portfolio, but holding up to 80% in stocks when they are "undervalued" and only 40% when "overvalued", according to their formula. All you are doing is buying more stocks after prices have fallen and risk is higher, that's not alpha or passive investing, that's active management. Its a deviation from the policy portfolio based on perception of mispricing.

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Re: Fundamental Index Funds

Postby ClosetIndexer » Tue Mar 26, 2013 4:09 pm

Yes, most funds have some sort of process for security selection. However, with an actively managed fund, analysis and judgement play a role. A fund that strictly adheres to a formula, and does not regularly change that formula, is the definition of passive, at least in my opinion.

If Vanguard created a balanced fund that varied its equity exposure as a linear function of P/E, for example, I agree that that would also be a passive fund. If, on the other hand, they varied exposure based on the manager's discretion, with the manager taking into account P/E (as well as potentially other factors) to make that determination, that would be active.

That said, as long as someone understands what a fund is doing, the label we give it does not make much of a difference. I don't care what RAFI calls their funds; I just care what my rolling regressions show me regarding their factor loadings and alphas over time. (And of course, they are not alone in the fact that their loadings change, even amongst those who endeavor to keep them the same.)
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Re: Fundamental Index Funds

Postby EDN » Tue Mar 26, 2013 4:27 pm

ClosetIndexer wrote:Yes, most funds have some sort of process for security selection. However, with an actively managed fund, analysis and judgement play a role. A fund that strictly adheres to a formula, and does not regularly change that formula, is the definition of passive, at least in my opinion.

If Vanguard created a balanced fund that varied its equity exposure as a linear function of P/E, for example, I agree that that would also be a passive fund. If, on the other hand, they varied exposure based on the manager's discretion, with the manager taking into account P/E (as well as potentially other factors) to make that determination, that would be active.

That said, as long as someone understands what a fund is doing, the label we give it does not make much of a difference. I don't care what RAFI calls their funds; I just care what my rolling regressions show me regarding their factor loadings and alphas over time. (And of course, they are not alone in the fact that their loadings change, even amongst those who endeavor to keep them the same.)


"With an active fund, analysis and judgement play a role". With RAFI, the analysis and judgement play a role as well-- it is incorporated into the trading and weighting algorithm. The managers decide on the trading rules. They are two sides of the same coin. Whether you derive your changes based on feeling or fundamentals, or are instituted based on manager discretion or quantitative screen, they are changes none-the-less. Ask yourself this: why make changes? Why not just stick with constant exposure to size or value? If there are times to be more value oriented, and times to be less value oriented, you are implicitly saying sometimes market prices are right (high risk = high return), other times not (high risk =/= high return) in a way you can forecast more consistently than the rest of the market.

I agree that its important to know what a fund is doing (active or passive), I just don't think with RAFI you'll be knowing what they are doing. Are they more growth oriented or more value oriented? Is value currently priced right or wrong? And based on FF3F regressions, will alpha be due to good timing calls or good implementation? With a truly passive fund without time-varying exposure, you know its all about 3F sensitivities and alpha (which measures implementation and also any issues with how the factors are calculated). With time-variation in underlying exposure to factors, you have another variable to evaluate, and disentangling trading gains from implementation gets very difficult.

Here is an easy way to think about it. Lets say you have 2 funds, both with AAPL as your biggest holding. When it comes time to trade, AAPL is sold from both. Fund one sells it because it no longer meets a price/valuation ratio all stocks must meet at all times. Fund two sells it because their fundamental assessment of the market and current pricing determines that different types of stocks now should be held and in different percentages which differ from previous determinations, because they offer better risk adjusted returns today. Fund 1 is a passive value fund. Fund 2 could be RAFI, it could be an actively managed fund, no way to know.

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Re: Fundamental Index Funds

Postby larryswedroe » Tue Mar 26, 2013 4:31 pm

Eric the problem, or our disagreement, is in your last paragraph above.
which is why I agree with closet indexer

That idea about mispricing you state as the reason for selling is baloney. Arnott IMO created a theory so he could market his different indices and get paid for it. That was his theory. But that doesn't hold up. You could have this fundamental footprint as your screens and not have it based on some mispricing idea. After all his indices are nothing more than a value and size tilt. IMO you could make the same argument about BtM as value being a behavioral story, so you sell if BtM falls because it's no longer mispriced.

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Re: Fundamental Index Funds

Postby Random Musings » Tue Mar 26, 2013 7:16 pm

Index Universe ran a report on PowerShares RAFI funds in November. They slashed the expense ratio's from the 0.85% range (roughly) to the 0.45% or so range. Assets in those shares were not impressive, so I guess this was their attempt to get more AUM. I wonder how that has helped.

When I look at the PowerShares FTSE RAFI US 1500 Small-Mid, for example, the small load is there, but M* doesn't show any meaningful value tilt. It's basically right in the middle.

Looking at PowerShares FTSE RAFI Dev Mkts ex-US S/M, M* shows mid-cap loadings, with some tilt.

At 0.45% to 0.50%, I still don't see it. Either not enough small or not enough value.

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Re: Fundamental Index Funds

Postby ClosetIndexer » Tue Mar 26, 2013 8:05 pm

Random Musings wrote:When I look at the PowerShares FTSE RAFI US 1500 Small-Mid, for example, the small load is there, but M* doesn't show any meaningful value tilt. It's basically right in the middle.


That may be because Morningstar boxes don't have sufficient granularity, and/or their analysis may be out of date. Here's what I get for PowerShares FTSE RAFI US 1500 Small-Mid from inception to 2013/01:

Code: Select all
                                RM-RF     SMB     HML     MOM    Alpha (annual)
    RAFI US 1500 SM              1.01    0.89    0.22    -0.16     1.43%
       Std. Error                0.03    0.07    0.06     0.03     1.69%   R^2 = 0.976



Not a massive HML, but certainly meaningful. "Small load" is an understatement though. If you have a bit of time, I really recommend doing the actual regressions; you get a lot more data than M* style boxes can give you.

Random Musings wrote:Looking at PowerShares FTSE RAFI Dev Mkts ex-US S/M, M* shows mid-cap loadings, with some tilt.


Since there are no 'official' international developed factors provided by Dr. French, we need to roll our own. I use this technique. It would take a bit more time than I have atm to update my international developed factors to 2013, but here's what I get through June 2012 for PDN (FTSE RAFI Dev Mkts ex-US S/M):

Code: Select all
                                RM-RF     SMB     HML    Alpha (annual)
    PDN                          0.98    0.45    0.21     3.32%
       Std. Error                0.03    0.12    0.07     2.48%   R^2 = 0.966



Due to the technique I use to estimate the factors, as described in that thread, that's probably a slight overestimate of SMB and a slight underestimate of HML. So true values would be closer to 0.35 +/- Std. Err. for SMB loading, and 0.3+/- for HML loading. AKA, mid-cap, mild value tilt - roughly in line with the Morningstar estimates. (The estimated factors are more useful for comparing similar funds than for stand-alone assessments, but nice to see that they're consistent here.)
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Re: Fundamental Index Funds

Postby stlutz » Tue Mar 26, 2013 10:53 pm

I think Arnott's theory is more straightforward that the theories that get thrown around here about small/value tilting. His weighting scheme, equal weighting or other similar ideas are after "mispricing". Mispricing would vary through time and different securities are going to be mispriced at any given time as well. Stocks with a low P/B ratio could actually be overpriced based on their growth potential. Fundamental indexing and equal weighting attempt to gain from that type of mispricing as well.

The small/value people are essentially arguing that stocks selling in the bottom half of Price/X are mispriced, always have been mispriced, and always will be mispriced.

If a particular type of stock has an overwhelming likelihood of beating the market without some big tail risk to go along with it, it by definition has to be mispriced. People disagree about the best ways to go in search of mispricing, but nobody should ever be confused that mispricing is the holy grail the the investment community is always going in search of.
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Re: Fundamental Index Funds

Postby ClosetIndexer » Tue Mar 26, 2013 11:17 pm

stlutz wrote:I think Arnott's theory is more straightforward that the theories that get thrown around here about small/value tilting. His weighting scheme, equal weighting or other similar ideas are after "mispricing". Mispricing would vary through time and different securities are going to be mispriced at any given time as well. Stocks with a low P/B ratio could actually be overpriced based on their growth potential. Fundamental indexing and equal weighting attempt to gain from that type of mispricing as well.

The small/value people are essentially arguing that stocks selling in the bottom half of Price/X are mispriced, always have been mispriced, and always will be mispriced.

If a particular type of stock has an overwhelming likelihood of beating the market without some big tail risk to go along with it, it by definition has to be mispriced. People disagree about the best ways to go in search of mispricing, but nobody should ever be confused that mispricing is the holy grail the the investment community is always going in search of.


Actually, the standard argument behind small and value premiums is not based upon mispricing. Rather, small and value portfolios are exposed to additional risks, which are, at least in part, independent from equity risk. Therefore, their higher average return is rational, not the result of mispricing. "Risk story," is the term you will hear thrown around most often.

A description of fundamental indexing exploiting mispricing may be more straightforward than a multifactor explanation, but that doesn't make it right! ;)
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Re: Fundamental Index Funds

Postby EDN » Tue Mar 26, 2013 11:40 pm

stlutz wrote:I think Arnott's theory is more straightforward that the theories that get thrown around here about small/value tilting. His weighting scheme, equal weighting or other similar ideas are after "mispricing". Mispricing would vary through time and different securities are going to be mispriced at any given time as well. Stocks with a low P/B ratio could actually be overpriced based on their growth potential. Fundamental indexing and equal weighting attempt to gain from that type of mispricing as well.

The small/value people are essentially arguing that stocks selling in the bottom half of Price/X are mispriced, always have been mispriced, and always will be mispriced.

If a particular type of stock has an overwhelming likelihood of beating the market without some big tail risk to go along with it, it by definition has to be mispriced. People disagree about the best ways to go in search of mispricing, but nobody should ever be confused that mispricing is the holy grail the the investment community is always going in search of.


Stultz,

First, we''re all "small/value people", as the 3F model is the state of the art asset pricing model describing what drives returns (the 3 factors drive 96% of the variation in diversified portfolio returns). You can tilt to small or value, or not, but you are investing in a multi-dimensional market either way. Can't run from that.

Next, size and value are not due to mispricing. Markets aren't 100% efficient, but close enough. If s/v were due to errors, we'd see them exploited by active managers. But no, a well-engineered asset class fund accepting the risks, choosing to target the factors broadly and focus on keeping costs down outperform 90%+ percent of them. Many studies document the risks.

Finally, not all investment management is about finding mispricings. Some seek to diversify broadly, manage costs, and fully deliver well documented sources of return that carry associated risks.

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Re: Fundamental Index Funds

Postby ClosetIndexer » Tue Mar 26, 2013 11:50 pm

EDN wrote:Finally, not all investment management is about finding mispricings. Some seek to diversify broadly, manage costs, and fully deliver well documented sources of return that carry associated risks.



And some appear to accomplish the latter while attempting the former! :wink:

I do agree with you btw that all else being equal I'd rather invest in a fund that attempts to hold factor loadings relatively constant than one that intentionally varies them. In the US for example, I'm happy with what can be achieved with solely Vanguard funds. Internationally though, options are a lot more limited, and something like PDN looks pretty good in comparison.
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Re: Fundamental Index Funds

Postby stlutz » Wed Mar 27, 2013 1:36 am

Actually, the standard argument behind small and value premiums is not based upon mispricing. Rather, small and value portfolios are exposed to additional risks, which are, at least in part, independent from equity risk. Therefore, their higher average return is rational, not the result of mispricing. "Risk story," is the term you will hear thrown around most often.


Nobody has ever sold small/value tilting on this forum because it's riskier; it's sold because it's going to beat the market.
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Re: Fundamental Index Funds

Postby ClosetIndexer » Wed Mar 27, 2013 4:17 am

stlutz wrote:
Actually, the standard argument behind small and value premiums is not based upon mispricing. Rather, small and value portfolios are exposed to additional risks, which are, at least in part, independent from equity risk. Therefore, their higher average return is rational, not the result of mispricing. "Risk story," is the term you will hear thrown around most often.


Nobody has ever sold small/value tilting on this forum because it's riskier; it's sold because it's going to beat the market.


I myself have discussed the unique risks involved in tilting in the past, as have many others. Obviously you don't tilt because it results in higher risk, but rather because given your personal situation, you are willing to accept that risk in exchange for potentially higher returns, and/or less risk of other types (ie: standard deviation). In a way though, having an underlying risk story is indeed a good thing, because it means the effect should persist.

Certainly some argue that the small and value premiums are entirely due to behavioral biases, just as Arnott suggests that his funds will outperform due to mispricing. It's far from a generally accepted opinion however.
Last edited by ClosetIndexer on Wed Mar 27, 2013 1:58 pm, edited 1 time in total.
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Re: Fundamental Index Funds

Postby larryswedroe » Wed Mar 27, 2013 8:20 am

stlutz
But there is no mispricing story here. At least as Arnott explains it. There is no logical reason to believe that the stocks with the largest market cap are the most mispriced. Very easily could be the smallest stocks are the most mispriced

Also I don't know how you could be more wrong about this statement "Nobody has ever sold small/value tilting on this forum because it's riskier; it's sold because it's going to beat the market."

I cannot even count the number of times I have posted a list of papers that demonstrate risk stories for size and value premiums, nor how many times we have discussed the issue of is the value premium behavioral or risk (with my own conclusion being it's some of both). And I'm certainly not the only one who has stated these things

And my books have also discussed the risks of investing in small and value stocks

In addition, I have discussed how you could use the factors not to outperform the market per se but to lower the exposure to beta risk and thus cut tail risk

Best wishes
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Re: Fundamental Index Funds

Postby Default User BR » Wed Mar 27, 2013 12:13 pm

stlutz wrote:Nobody has ever sold small/value tilting on this forum because it's riskier; it's sold because it's going to beat the market.

That's untrue. It has been mentioned frequently that the most likely explanation for historic out-performance is risk rather than inefficiency.


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