A recent study by Rob Arnott says it paid to use fundamental indexing in the decade of The Aughts. Rather than losing money, you would have earned a small return. Sure, Arnott, a pioneer in fundamental indexing, has an ax to grind. He is, after all, chairman of Research Affiliates, which creates fundamental indexes and subadvises for PIMCO, Schwab and other asset managers.
Fundamental indexers weight stocks based on fundamental metrics, such as aggregate earnings, sales, price to book, cash flow and dividends, rather than on market value a la the traditional cap-weighted indexes, such as the S&P. The idea is to avoid over-priced stocks.
In this research report, Arnott shows how you would you would have done in a traditional 60/40 portfolio if you had replaced the S&P 500 cap-weighted index with the FTSE RAFI US 1000 (Research Affiliates' fundamental index). The annualized return moves from a negative 2.3% to 5.8%.
Old indexing hands, such as former Vanguard chairman John Bogle and Princeton finance professor Buron Malkiel, thought it unlikely that fundamental indexes would consistently outperform cap-weighted benchmarks, because of the new paradigm’s inherently higher operating expenses, greater portfolio turnover rates and heavier tax burdens.
Registered Rep. contributing editor Brad Zigler came to a similar conclusion when I asked him to investigate fundamental indexers' claims that they actually live up to their billing. Zigler did indeed find a slightly better return by using funamental indexes. But he didn't find a marked reduction in volatility, even as measured by the Sortino ratio which attempts to focus on downside volatility and not upside volatility. His story will be published in the February issue of Registered Rep. and online later this afternoon. Stay tuned.