Rob Arnott, founder of Newport Beach, Calif.-based Research Affiliates, says the RAFI indexing revolution is gathering steam. Armed with a growing track record of real funds with real returns, he told IndexUniverse.com Managing Editor Olivier Ludwig it’s becoming more difficult for critics to defend cap-weighted indexes.

He pointed to the growing popularity of equal-weighted indexes as further evidence that investors are becoming more aware that cap-weighted indexes aren’t the only way to go, and grew excited about new funds using his company’s system, including the ProShares RAFI Long/Short ETF (NYSEArca: RALS).

Ludwig: How is the RAFI revolution shaking out at this point from where you sit?

Arnott: The RAFI revolution I think is well under way. I think we’re finding that the notion of moving away from cap weight, as the preferred approach to indexing, is well under way. What was a radical idea back in 2005 is becoming very well accepted and is part of a much larger movement.

For example, equal weighting is now starting to gain some serious traction in the marketplace, and the notion of equal weighting has been around since S&P introduced their equal-weighted index in 1990.

So, I think the fundamental index revolution is gaining enormous traction. Last year we saw growth from $29 billion in RAFI assets at the start of the year to about $46 billion at the end of the year. That’s huge.

Ludwig: Is it fair to characterize you as one of the early adopters?

Arnott: One might fairly say I am the inventor, because the patent and trademark office gave us patents on it.

Ludwig: So, are your competitors able to dodge that patent protection you have by not going with the full four fundamental factors RAFI uses, and instead using two factors, like, for example, WisdomTree does?

Arnott: Let’s not dive into that because that’s a fluid area. That would require me to speculate on legal questions about what is infringement.

Ludwig: Fair enough. I guess another way of skinning the cat is, why the four factors sales, earnings, dividends and book value? Could one have more parameters?

Arnott: You could have more parameters. You could have fewer parameters. The key is not what measures you use, the key is to have a stable anchor to contra-trade against the market’s most extreme bets. And it doesn’t matter what anchor you use. You could use fundamental weighting. You could use equal weighting. You could use the number of board members who wear bow ties. All of these weighting schemes break the link between price and the size of our investment. The problem with cap weighting is that it will systematically increase exposure to a company as the company becomes expensive.

Ludwig: So, who do you view as your competitors?

Arnott: Things like equal weighting, DFA’s value indexes, minimum variance, efficiency-weighted portfolios all come to mind. But I wouldn’t call them competitors. I would call them interesting new entrants into the world of noncap indexing. And I think what we are seeing is a tidal wave of interest in noncap indexing. That’s what I find really exciting.

Ludwig: There are plenty of spoils to go around, is what you’re suggesting?

Arnott: Right. So I’m actually rooting for all of these ideas to gain some traction in the marketplace, because I think they all have their own legitimacy. Some of it is independent legitimacy for ideas that have unique elements to them, and some of it is shared. The shared advantage for all of them is that we don’t weight companies according to how expensive they are.

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