Indexing minus market cap: A novel idea

BRIAN MILNER
Saturday, June 7, 2008

It's tumultuous days like yesterday in the markets that underline why so many investors prefer their action to be passive. And why a small but growing number of them are turning to indexes based on the actual financial strengths and economic footprints of companies, rather than their stock market price.

The day began in typical fashion of late. Some analyst issues another hugely bullish forecast for oil - in this case a call by Morgan Stanley of $150 (U.S.) a barrel within a month - the price skyrockets into record territory and the S&P/TSX composite index is off and running toward a record high of its own. At the same time, the benchmark U.S. indexes take it on the chin, as gloomy job news and a weakening U.S. dollar blend with the oil-price scenario to bring out the beads of sweat on traders' brows.

Retreating investors halted a rally that had boosted the S&P 500 by 10 per cent from its low-water mark in March. The Dow plunged almost 400 points.

Meanwhile, the Canadian benchmark index finished with a slight loss, as investors inhaled some of the legitimate pessimism wafting over the border. All of which shows that these are not markets for people who get queasy when riding roller-coasters.

Buying index funds would be better for sleeping - and definitely cheaper than paying an active money manager, whose chances of beating the market under any conditions (if costs are included) are slim.

Looking for the right index funds brought me to Rob Arnott, who has just co-written a book called The Fundamental Index, which delves into a strategy he is convinced will revolutionize the $5-trillion (no, that's not a misprint) index fund industry. It also brought me, unwittingly, into the midst of a nasty squabble.

His firm, Research Affiliates, is the architect of fundamental indexing, which assigns weightings based on a combination of measures of economic success - sales, profits, book value and dividends. It ignores market capitalizations (usually floats), which are the basis of all traditional indexes.

Fundamental indexing is a simple and compelling idea, born out of frustration over what happened when the tech-stock bubble burst. At the time, passive investors who thought they were playing it safe by buying products that mimicked the supposedly broad S&P 500 index lost hundreds of billions because Cisco and other tech stocks had huge weightings when they imploded.

The same thing happened in Canada thanks to Nortel, which accounted for 28 per cent of the value of the Canadian market at the height of the bubble. By weighting stocks based on their market size, "they were ensuring that they would overweight overvalued companies and underweight undervalued companies," Mr. Arnott says from his office in Pasadena, Calif.

If someone had pointed out this obvious problem when the S&P 500 was born 51 years ago and the designers had chosen instead to weight companies based on their economic footprint, "cap weighting would be merely a quaint academic concept today with no money attached to it."

These are fighting words to the proprietors of vast index fund empires, such as John Bogle, the founder of Vanguard Group, who says fundamental indexing is just another twist on value investing, that it isn't passive and that it isn't indexing.

"To me, that misses the core issue," Mr. Arnott says. "If you define index such that it has to be cap-weighted, then, fine, this isn't an index. If you define index to mean something that's low turnover, broadly representative of the market or the economy, that is formulaic, objective and mechanistic, this qualifies."

In three short years since Research Affiliates turned the fundamentalist idea into real products, it has grown from a few million in assets to about $35-billion. Two smaller competitors have sprung up, with less than $10-billion combined. That's not even 1 per cent of the total invested in traditional indexes, so it's not as if fundamental indexing is gobbling up huge amounts of market share.Playing the S&P/TSX composite index today is largely a bet on energy and materials, with a few other high fliers like RIM thrown into the pot. Should Potash Corp. really be the second-most important company in the index with a weighting of 4.5 per cent, slightly behind EnCana?

Not in economic terms. Potash Corp. ranked 29th in profit last year, trailing the likes of ACE Aviation and Telus in both revenue and earnings. EnCana stood fourth.

When commodities go the way of all bubbles, plenty of index players might be wishing they owned a vehicle that better reflected that fact.