The Fundamental Debate - JOI Articles

January / February 2009
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The Fundamental Debate

Written by Paul Kaplan vs. Robert Arnott

Thursday, 01 January 2009 00:00

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Moderator: Paul Kaplan asks, "Doesn't fundamentally weighted indexing assert that all stocks should have the same PE, where E is a proxy for earnings or dividends—whatever you're dividing price by—while market-cap-weighted indexing is an argument that the different PEs that are put on the various stocks by the market are correct." What evidence do you have, Rob, that all stocks having the same PE is a better approximation of the economic values of the companies than all market PEs being correct?

Arnott: I have no evidence that all stocks being at the same PE ratio is a better representation of fair value for companies than the market price … indeed, the evidence runs to the contrary. I've done some new work on a notion that we refer to as "clairvoyant value," in which you take historical prices and you ask, "What were the subsequent cash flows from that investment actually worth?" I found something interesting—unsurprising, but startling in its magnitude—that companies trading at premium multiples have subsequent growth relative to companies trading at discounted multiples, which is highly correlated with those multiples. That excess clairvoyant value is correlated with the ex-ante pricing with a 50 to 60 percent correlation; it's awesome. So the market is doing a brilliant job at gauging which companies deserve premium valuation multiples. What we also found is that a fair spread between growth and value stocks is about 40 percent for the one-sigma outliers, while the actual average spread is about 80 percent; so the market pays up for growth about two-to-one relative to what it should pay up.

Moderator: So you're saying the market can forecast which companies are going to grow but then assigns too high a multiple for those companies?

Arnott: Exactly. The way the Fundamental Index approach adds value is categorically not to have a better representation of fair value. Categorically, it is to have a sensible and intuitive anchor for rebalancing. Most of us in the investment world believe that rebalancing is an important part of our tool kit. Why do we have rebalancing stop at the borders of the stock market? Why do we want to have 31 percent in technology at the peak of the bubble in 2000, rather than having a rational anchoring mechanism for rebalancing and contratrading against the excessive bets, in either direction, that the market will make from time to time?

Moderator: Paul, do you think that there's an aspect of fundamentally weighted indexing that hasn't been discussed that causes it to have some flaw? I ask this because if the market can distinguish between companies that are going to have future high growth rates, and companies that are not, then there is information in the price, which ought not to be completely ignored.

Kaplan: Well, I think that suggests that the market price should not be ignored if the market actually does a good job of identifying companies that have future growth.

Arnott: I think a lot of the controversy about the Fundamental Index idea is that so many people have trouble shifting their frame of reference from owning stocks, and thinking of the market-cap-weighted way of owning companies, and thinking of the company scale as the anchor. Ultimately if a company is at a premium multiple, one of two things must happen. Either the [corporate fundamentals] must eventually rise to show that that premium valuation multiple is fair. Or the price must fall to correct that error. And so, if we grant that there is that mean reversion tendency, then ultimately the one scenario in which the Fundamental Index idea would be expected to under-perform is a scenario in which the market is paying too little premium for the growth that it anticipates. That is to say that the market discerns growth and value but has the opposite of hubris—inadequate confidence in its ability to discern opportunity—and pays too little a premium for growth relative to value. In that scenario, the Fundamental Index approach would under-perform.

Kaplan: I think what you're describing is the principle of value investing: that the market prices are not equal to fair values, but over time the differences are eliminated. This is the principle of value investing that goes back at least to Graham and Dodd. So you're enunciating principles with which we've all been very familiar in this industry for many decades. And so I view what you're doing in fundamentally weighted indexing as simply an automated passive approach to …

Arnott: I'm shocked, shocked that you used the word passive! But go on.

Kaplan: … passive in the sense that you can do it with a computer. You don't need an analyst to execute the strategy.

Arnott: I have never claimed to invent fundamental investing. I have never claimed to invent value investing. What I have, I think, done is to come up with a new method of constructing a portfolio. You can call it indexing. We do. You can call it an active strategy. Others do. But it is a portfolio that simply mirrors the look of the economy. And what we've shown, through vast empirical evidence, is that historically that captures a lot of return that is left on the table by cap weighting, with its chasing of bubbles, crashes, fads and shifting expectations. It's not the value tilt, on average over time, that creates the incremental return, it's the contratrading against the market's constantly shifting bets.

Kaplan: I'm not sure I see a distinction. But, I guess, one thing I would point out is that the idea of using a measure of the economic footprint rather than market capitalization in constructing your index … I believe the credit should go back several decades to MSCI, for they created the GDP-weighted index. You all remember back in the late '80s when on a market-capitalization basis Japan had this huge weight which everyone thought was ridiculous. So the way it was corrected, or addressed, was to use GDP weighting.

Arnott: I would agree that we weren't the first to use fundamentally derived weights; absolutely right.

Moderator: GDP weights are a fairly close antecedent. I remember thinking that MSCI might lose a lot of business because it was so easy to beat the MSCI EAFE benchmark just by holding a below-benchmark weight in Japan during the '90s. But, in fact, during the '80s, the situation was the opposite: It was almost impossible to beat EAFE because Japan was the only country that was going up. So reweighting the index to a more fundamentally oriented set of weights did not necessarily produce a better index or a worse index, it was just a different index. It outperformed tremendously in the '90s, having underperformed in the 1980s. And we might expect something similar to happen to a fundamentally weighted index consisting only of U.S. stocks if you have a bubble and then a crash.

Kaplan: Which is exactly what happens if you look at the back history of a fundamentally weighted index through the bubble of the late '90s into 2000. When the bubble was rising, the fundamentally weighted index did very poorly relative to the market. But once the market correction came, the fundamentally weighted index was in all of the right places for the ensuing period in which value beat growth.

Arnott: One of the neat things about the Fundamental Index concept is that the magnitude of its bets varies with the magnitude of the bubble. For example, take the GDP weight—and I would absolutely agree that that has the same intellectual underpinnings of the Fundamental Index idea, and the same source of alpha. GDP weighting, when Japan started its bubble, was a neutral weight. But by the time the Japan market reached its peak, with GDP weighting, you had a maximum bet against Japan just when the bet was going to be most profitable. That's wonderful. It doesn't mean that you're going to win every quarter or every year. It does mean that the size of your bets will correspond to the magnitude of the markets' extreme bets. And the reciprocal happens on deep value. It's that rebalancing that's the principal profit mechanism, not the value tilt per se.

Moderator: In 1954, when the United States finally surpassed the 1929 peak in the stock market, a group of wise men, including John Kenneth Galbraith, advised President Eisenhower to prepare for another crash and another Great Depression. What the market was telling us, however, was that the United States was emerging as the dominant economy in the world, and the 1954 price which exceeded the 1929 high on the Dow Jones was actually a tremendous bargain. We all wish we, or our grandfathers, had gotten in at that price. The Japanese bubble could have been the same phenomenon. It could have been actually a bargain. At the time, it was hard to figure out. In retrospect, it's easy to figure out because we know what happened later. How does fundamentally weighted indexing reflect the possibility that you might be wrong about when something is in a bubble or overpriced?

Arnott: Suppose we could take the net present value of all future cash flows on every company and calculate it back to today and identify a current fair value based on the ex-post realized cash flows. Now, suppose I have those numbers and nobody else does. And suppose I come to all of you in the audience and say, "Here's the cap-weighted portfolio and here's the true-fair-value-weighted portfolio. I can't tell you if the true-fair-value-weighted portfolio is going to do better or worse today, tomorrow, this year. But I can tell you that the true-fair-value-weighted portfolio is correct, exactly the fair-value weightings. How many people in this room would choose the cap-weighted portfolio? Right; nobody would. Not a single person.

If we have a cap-weighted portfolio, we know most of our money is in companies that are above fair value, whether they're high or medium or low valuation multiples. We know that they're going to revert toward fair value over time. And so we know that most of our money is in assets that are going to under-perform and too little is in assets that are going to outperform.

The fascinating question is if you can construct a portfolio which has a clairvoyant value weight, plus or minus random noise. Mathematically it will have the clairvoyant value portfolio return, minus a tiny drag from the noise, but not minus a systematic drag for overweighting the overvalued parts and underweighting the undervalued. We went back over the last 50 years and looked at company size and took the correlation of the gap between clairvoyant value, the subsequent and realized value, and share price—i.e., the error in that initial price—and posed the question, "Is that correlated to the company size?" The short answer was no. The average correlation was zero, which means that, over the last 50 years, the fundamentally weighted portfolio would have had almost exactly the same return as that clairvoyant value portfolio that we all agreed would be the better choice. So really it's our randomizing of the errors, instead of systematically overweighting the overvalued and underweighting the undervalued with cap weighting, that's the source of the value added.

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