New Take on Index Fund Concept

In the 4th century BC, Aristotle proposed that the known universe revolved around Earth.

We now see the absurdity of that idea, of course, yet it sounded logical enough to hold sway for about 1,800 years, until Copernicus suggested a then-outrageous alternative.

Robert Arnott, a Pasadena-based money manager, thinks the modern investment business can learn something from Copernicus’ heresy: The industry, he says, should be less afraid to question conventional wisdom -- particularly when it’s deeply entrenched.

Arnott is a well-known name in investment circles who heads a firm called Research Affiliates. Since 2002 he also has served as editor of the Financial Analysts Journal, a forum for Wall Street pros, academics and others with a serious interest in finance.

A statistics whiz with a passion for vintage motorcycles, Arnott has used his journal editorials to poke at many classic investment dogmas, question their application in the real world and effectively challenge his peers to wonder whether there are better ways to construct clients’ portfolios.

Lately, he has been focused on a portfolio of immense proportions: the estimated $1.7 trillion that U.S. investors have in index stock funds, most of which seek to replicate the performance of the blue-chip Standard & Poor’s 500 index.

The vast majority of market indexes, and the funds that track them, are capitalization-weighted -- meaning, the stocks that dominate the indexes at any moment are the biggest issues in terms of market capitalization (a company’s share price multiplied by the number of shares outstanding).

Arnott contends that is fundamentally flawed. Why? Think about the technology companies that were paramount in the market in March 2000, at the peak of the dot-com mania.

In a capitalization-weighted index, “You automatically overweight all the overvalued stocks,” Arnott says.

A better way to construct an index, he maintains, would be to weight stocks based on measures of what firms actually have accomplished, rather than solely on the often fleeting beauty contest of stock capitalization.

He calls his concept “Main Street indexing,” as opposed to the “Wall Street indexing” of capitalization weighting.

The 50-year-old Arnott and his peers at Research Affiliates have spent the last few years developing an indexing system using such measures of business success as five-year average sales and operating earnings, employment and net asset value.

Now, he’s taking his Main Street index to Main Street: Newport Beach-based Pimco (short for Pacific Investment Management Co.) this week will launch the Fundamental Index Plus portfolios, two mutual funds based on Arnott’s system.

Not surprisingly, the central pitch is that investors should earn more over time with Arnott’s index than in standard capitalization-weighted indexes. That’s because his system is designed to avoid holding too much of the index in stocks that already are highly valued -- allowing more to be invested in shares that, in theory at least, are undervalued and thus have greater future return potential.

His index still will hold 80% of the stocks found in the Russell 1,000 index, a benchmark of the biggest U.S. companies, Arnott says. But because the percentage weighting in each stock will differ from a capitalization-based formula, the index’s performance also will differ, he says.

Back-testing from 1962 through 2003, Arnott says, a 1,000-stock portfolio that followed his indexing model generated an average annual return of 12.4%, beating standard indexes of major U.S. stocks by as much as 2% a year.

Arnott faces plenty of skeptics who say he short-changes the appeal and logic of capitalization-weighted indexing. They also say his indexing technique is too unwieldy or is unlikely to produce above-average long-term returns in practice. Or both.

Gus Sauter, chief investment officer at giant Vanguard Group, which has built its mutual fund business on capitalization-weighted index portfolios, says he has known Arnott for nearly two decades, and considers him “a very smart guy.”

But Sauter sees Arnott’s Main Street stock-weighting idea as just another variation on an increasingly common theme: attempts by money managers to tweak traditional index investing in search of the best of both worlds -- a “passive,” buy-and-hold portfolio that largely tracks the market, but with some added oomph that produces a net return better than the market.

Such variations inevitably mean tilting an index portfolio toward particular market sectors, such as smaller stocks, Sauter said. As long as those sectors are booming, the portfolio will beat the market return -- but only for that long, he said.

“I think he really hasn’t created anything new,” Sauter said of Arnott’s concept.

Pimco’s Brent Harris is a believer, however. The chairman of the Pimco funds said Arnott’s work has helped convince him that “the study of indexes themselves is a wildly underlooked-at topic.”

Harris also likes the Main Street indexing method on principle, he said, because it is based on fundamental factors that investors naturally consider in picking stocks.

Arnott’s reputation at Pimco already has been burnished by the success of the Pimco All Asset Fund, which he has been managing since its inception three years ago.

Pimco, best known for its bond funds, in recent years has added portfolios that use derivative securities to invest in real estate and commodities. Harris said he thought that such diversification was an important option for investors because Pimco expected returns on stocks and bonds to stay relatively low for an extended period.

In 2002, Harris had the idea for a “fund of funds” that could invest across all major asset classes, picking and choosing among Pimco’s portfolios.

He found a kindred spirit in Arnott, who also has been forecasting weak returns from traditional markets; Pimco hired Research Affiliates to manage the All Asset fund.

Since its launch, the fund has generated a 14.3% average annual return, and cash has poured in, lifting assets to nearly $7 billion. The fund trailed the S&P; 500 in the stock market’s big comeback year of 2003 but beat it in 2004, and its Class A shares are up 3.5% year to date while the equity market has slumped.

Arnott and his staff decide each day how to allocate the All Asset fund’s money among Pimco funds based on mathematical models that seek to predict the long-term return potential of each asset sector.

Number crunching -- as compared with investing largely by gut instinct -- is the basis of “quantitative” investing, which is how Arnott got his start on Wall Street.

As a 6-year-old, he says, his idea of a challenge was calculating the average rate of curve in Earth’s surface (he came up with 8 inches per mile).

He toyed with the idea of becoming an astrophysicist, Arnott says, but found himself drawn to the investment world.

After graduating from UC Santa Barbara in 1977 with a triple major in math, economics and computer science, he held positions at several investment firms, including a stint as brokerage Salomon Bros.’ chief equity strategist, before starting his own fund management company, First Quadrant, in 1988 in Pasadena.

The company was later bought by Affiliated Managers Group Inc., but the relationship between Arnott and the new parent soured over time, he said. He formed Research Affiliates in 2002 and severed his last ties with First Quadrant last year.

Arnott isn’t shy about his opinions, a trait that endears him to some but may grate on others.

Some of his Financial Analyst Journal editorials have taken the money management industry to task, warning about the dangers of “intellectual laziness.”

He wonders, for example, why Wall Street thinks it is OK for many companies to continue to assume they’ll earn 8.5% a year or more on their employee pension assets when returns on stocks and bonds have dwindled in this decade. If companies and their investment managers were realistic about potential returns, they would have to lower them, Arnott says.

As a numbers purist, he also has attacked those who oppose the expensing of employee stock options on corporate income statements. “We’re the only country in the world where stock options aren’t treated as an expense,” Arnott says.

In general, he believes that many long-held financial theories could use a thorough airing-out -- not unlike what Copernicus’ ideas did for (or to) man’s view of the universe.

Arnott is hoping that the sound of his new stock indexing concept on Wall Street will be the equivalent of his beloved Vincent Black Lightning motorcycle rolling into town. He was planning to ride that one in a rally this weekend, he says. “It will be,” he says, “the loudest bike there.”

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Tom Petruno can be reached at [email protected].