A Brilliant New Way to Weight an Index

Thursday, June 24, 2010

Research Affiliates logoReinventing the index fund

Rob Arnott is "one of the most important figures working in the investment world today," said Shawn Tully in Fortune. The founder of Research Affiliates advocates a strategy he calls "fundamental indexing." Most index funds hold stock in proportion to the relative values of the companies' market capitalizations; Arnott allocates his investments by also taking account of sales, cash flow, book value, and dividends. This approach tends to eschew expensive stocks in favor of "value"--and it seems to work. Over the past five years, Arnott's flagship index, FTSE RAFI US 1000, has beaten the Standard & Poor's 500 by 2.4 percentage points annually. "Arnott hasn't just beaten his competitors--he's thrashed them." (The Week)
This seems like an absolutely fantastic idea considering the growth in exchange traded funds and many investors' desire to index their money for very low fees. It seems to me that it would be relatively easy to create a fundamental factor model that adjusted weightings of securities in the index accordingly rather than a simplistic market capitalization method. Given the valuation distortions in the technology sector in the late-1990s or financials in the mid-2000s, this could be an excellent way to automatically adjust a portfolio of stocks yet remain highly diversified and pay very low fees. Why doesn't Vanguard have this yet?
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