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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Kaplan: With respect to price, what you're calling a randomized error is not, in fact, a randomized error; it is in fact the fair price multiple.

Moderator: Please develop that idea, Paul. We haven't all read and carefully studied your paper. As I understand your paper, it's a very fully developed argument that what Arnott and [Jason] Hsu call a randomized error is actually correlated to the market so that it's not random at all. This point is the key to understanding why your position differs from Rob's; otherwise, it sounds like you're sort of both marching towards the same goal with a 0.8 correlation. You're not.

Kaplan: The point is, how do these weights that are created from fundamental variables differ from those created from fair values? It's just a simple mathematical truism that if I take the ratio of one to the other, I get the fair market multiple, which is a component of how the market is going to be priced. And therefore, this so-called random error term is not a random error term at all. It is, in fact, reflected in the market capitalization.

Arnott: That's exactly right.

Kaplan: But Jason says in his paper that it's independent of market capitalization. So there's an internal contradiction that I'm seeing in the logic here.

Arnott: There is not. You have price and you have fair value. The difference between the two cannot have zero correlation with both. In Jason's paper—and in our paper with Harry Markowitz—we make the assumption that the error is random, and uncorrelated with value. That means it must be negatively correlated with price. Now, classic efficient markets theory says the error is uncorrelated with price. And basically we reject that. We say that ultimately the two need to converge, and ultimately the anchor for value is the eventual future fundamental scale of the company. And because that's the anchor—and this is verified empirically on the clairvoyant value paper—we find that the error is utterly random relative to company scale, and it is empirically negatively correlated with price, which gets back to your point that value works; something that's been known for a long, long time.

Empirically it has worked in countless markets around the world over long periods of time, albeit with dry spells, with periods that are disappointing. But you would expect that in a world in which price equals fair value plus or minus a truly random noise term.

Moderator: Behavioral finance teaches that investors make systematic mistakes because they don't react rationally to information. Is it accurate to say that fundamentally weighted indexing relies on behavioral finance?

Arnott: I would be hesitant to endorse the notion that it relies on behavioral finance. The two are joined at the hip, though.

The presumption inherent in the Fundamental Index idea is that prices are wrong, and that eventually, the market identifies and corrects these errors. Therefore an anchor for rebalancing, even if it's the wrong anchor, winds up winning in the very long run. And so tacitly it does not rely upon a behavioral finance model for the world, but on the notion that prices are not exactly right at all times. That is a core principle of the Fundamental Index as a concept.

Moderator: Paul, does behavioral finance make sense to you, and if so, is it enough for investors to be irrational or to have knowledge deficits or information processing deficits to get fundamentally weighted indexing to be a worthwhile strategy? Or would you do something else with the behavioral insight?

Kaplan: Well, I think behavioral finance as it exists today is largely just a critique of classical finance, but it doesn't really present an alternative. The idea that the market does not price stocks correctly is the foundation of all active management in value strategies and in growth strategies. Since fundamentally weighted indexation is a value strategy, the idea is not something that's unique to fundamentally weighted indexing.

Arnott: When people say "value investing," they just mean a preference for a low PB and shun the growth stocks, like a classic Russell 1000 Value Index. Well, the Russell 1000 Value Index has a value tilt. It's about twice as much value tilt as the fundamental index. But it also cap-weights. So systematically it's going to overweight the overvalued value stocks.

The Fundamental Index approach—because of its very specific type of value tilt—winds up with half as much value tilt as the value index, adding twice as much incremental return, which is really cool.

Kaplan: Larry, I'd like to ask Rob a question ... What I see as a real controversy around fundamentally weighted indexing is the claims that are associated with it rather than the strategy itself. Jeremy Siegel published an article on the editorial page of The Wall Street Journal four days before they launched the product in which he made a claim that fundamentally weighted indexation represented a big revolution.

What he said was that basically, all classical finance is all completely wrong. It needs to be replaced by this new "noisy market hypothesis." So the market-cap-weighted portfolio disappears. The default portfolio becomes the fundamentally weighted portfolio. Rob, do you have a very different view than Jeremy has on that? Is that his view, and not yours?

Arnott: Our views are somewhat similar. But I'm certainly not going to reject the notion that there's been a certain amount of overselling of the Fundamental Index concept. If I've ever said anything factually incorrect, or materially exaggerating reality, I'd love to have somebody point it out to me. I don't think I ever have. And so the fact that some folks oversell and misrepresent, I have no comments about that. Yes, it's happened.

Audience Member: It was mentioned that the market price does a good job of identifying the company that is either growing faster or slower but it just exaggerates that effect in the price. Would there be a way that you could introduce something reasonably simplistic into a Fundamental Index approach that would, in fact, have some nonprice-related measure of reasonably expected future growth?

Arnott: Paul has, in a sense, done that with the collar strategy, which, I think, is a neat idea. We, at Research Affiliates, license the Fundamental Index approach through FTSE to anyone in the world who wants to license it. We don't run passive Fundamental Index money. By agreement with FTSE, we aren't going to compete with the licensees. We run enhanced Fundamental Index strategies and the enhancements are along the lines that you described. One of the enhancements that we use is quality of earnings; companies with poor quality of earnings that have a history of using aggressive accounting practices are smaller than they seem. And companies with conservative accounting standards are larger than they seem, and so we make that adjustment, and it's very profitable. So it's an illustrative example.

Kaplan: Consider two companies with the same earnings: a fast-growing company and a slow-growing company. Let's say you used the DCF model to assign weights. Both companies have the same earnings, which you divide by the cost of capital minus a company-specific growth rate. You end up with different weights. That's the kind of risk and growth adjustment that is not done in fundamentally weighted indexing as Rob has defined it. But certainly you'd think it would be a sensible thing to do because, again, your basic lesson of portfolio theory is that if two stocks have the same earnings, but they differ in risk or prospective growth, you don't hold them at the same weight.

Arnott: But you have to identify the high-growth versus the low-growth company in a fashion that is not in the price. Just because the high-growth company is at a high multiple and has high future growth, and the low-growth company has negative growth, that doesn't mean it's not in the price. In fact, your optimal portfolio might be sharply overweight the slow-growth company and underweight the fast-growth company.

Kaplan: Yes, but you're not using the market price. You would not use the market price. You would use a model of intrinsic value.

Moderator: If enough people fundamentally index, wouldn't a fundamentally weighted index converge to the cap-weighted-market-index return by mathematical certainty?

Arnott: Absolutely right. I hope it happens, and not just for the selfish reasons that you might infer. I hope it happens in the sense that if the world shifts from cap weighting to fundamental weighting, then valuation dispersion will gradually narrow and the two portfolios will become the same. What that means is that the early adopters will enjoy enormous wealth accumulation. When the alpha goes away, it doesn't have to go negative. It can just go away.

Moderator: Is there a downside to everybody adopting fundamentally weighted indexing, making all prices fair?

Arnott: That won't happen.

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