RAFI’s Founder Defends Fundamental Indexation

Earlier this week we published an article by Cris Heaton questioning whether fundamental indexing makes sense in emerging equity markets. Implementation costs may mean that fundamental index trackers fall short of their benchmark, while the impressive results produced by a fundamental index in back-testing may not give a fair reflection of what to expect in future, Heaton’s research suggested.

Rob Arnott, founder of Research Affiliates, the creator of the fundamental index approach, got in touch with IndexUniverse.eu editor Paul Amery to explain why he thinks his company’s methods stands up to scrutiny.

IndexUniverse.eu: Rob, does fundamental indexation make sense in emerging equity markets?

Arnott: Yes, and we thinks the results are pretty amazing. If you go back over twenty years you find that the fundamental index approach beats the market by around 8 percent a year. The notion of a dumb index doing this on a regular basis, without doing things like interviewing management and conducting research, like active managers do, is quite remarkable.

When we looked into the results we found that the capitalisation-weighted emerging markets equity index hadn’t even kept pace with an investment in local currency cash deposits in the countries concerned.

That cap-weighting produced a negative risk premium during a period of time when these economies grew 4 or 5 percent a year faster than the developed world is quite a strong indictment of that index method.

And the problem with active management in emerging markets is that active managers are typically anchored to the cap-weighted index and are wary of incurring tracking error against it. So they end up investing in the same globally recognised, often politically well-connected companies, which usually carry the highest valuation multiples.

So if you simply weight your emerging market portfolio according to companies’ local economic footprint, you’re automatically going to reduce your holdings in those most popular, trendy stocks.

The issue isn’t that fundamental indexation is so good in emerging markets, it’s that cap-weighting is so bad.

IndexUniverse.eu: In our article, we questioned whether in your performance back-tests you had taken into account “free floats” that may have been very limited for some emerging market companies. What’s your response?

Arnott: In our original back-test, published in 2005, we didn’t include a free-float adjustment. We introduced an adjustment in 2007. All of our back-tests were then revised to take free float into account. So, for example, if a company represents two percent of the local economy and half of the shares are privately held and non-tradeable, we would give it a one percent weighting in the index—regardless of market capitalisation.

IndexUniverse.eu: So when you adjusted your back-tests for free float what effect did this have on the performance results?

Arnott: It had almost no effect at all, which surprised me. I thought that the owners of companies with high levels of private ownership would care more about the success of their businesses, and their shares would therefore perform better, than companies which were not privately held. I therefore thought that de-emphasising privately held companies via the float adjustment would hurt fundamental indexation’s historical performance.

But it turned out that the float adjustment detracted only about 10-20 basis points a year from performance. That’s nothing, when compared with an 8 percent annual value added figure.

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