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Does Finance Theory Lead Us Astray? The Fundamentals of the
Fundamental Index® Concept
IQPC Indexing Strategies Asia 2007November 28, 2007
Hong Kong
Rob Arnott / [email protected]
For Educational Use Only
This presentation was created by Research Affiliates. This presentation contains the current opinions of the presenter, which are subject to change without notice. This
presentation does not represent a recommendation of any particular security, strategy or investment product.
2 For broker/dealer information only
Important Information
No disclosure may be made to third parties (including potential co-investors) regarding any information disclosed in this presentation without the prior permission of Research Affiliates, LLC. By accepting this document you agree to keep its contents confidential and not to use the information contained in this document, and in the other materials you will be provided with, for any purpose other than for considering a participation in the proposed transactions. You also agree not to disclose information regarding the transactions to anyone within your organization other than those required to know such information for the purpose of analyzing or approving such participation.
The material contained in this document is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. Research Affiliates and its related entities do not warrant the accuracy of the information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this material should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.
Any information and data pertaining to indexes contained in this document relates only to the index itself and not to any asset management product based on the index. No allowance has been made for trading costs, management fees, or other costs associated with asset management as the information provided relates only to the index itself. With the exception of data on Research Affiliates Fundamental Indexes, all other information and data are based on information and data available from public sources.
Any inquiries relating to the transactions should be directed to Research Affiliates, LLC.
The trade names Fundamental Index, Fundamental Indexing, RAFI, RAFI-Global, Fundamental Global, Fundamental K, Fundamental Q, Fundamental REIT, Fundamental 100, Fundamental 200, Fundamental 250, Fundamental 1000, Fundamental 2000, Fundamental 3000, Global Fundamental, Research Affiliates, Mainstreet Index, Mainstreet Indexing, Synthetic Strips, Virtual Mutual Fund, the RAFI logo and the Research Affiliates corporate name and logo are the exclusive intellectual property of Research Affiliates, LLC. Any use of these trade names and logos without the prior written permission of Research Affiliates, LLC is expressly prohibited. Research Affiliates, LLC reserves the right to take any and all necessary action to preserve all of its rights, title and interest in and to these terms and logos.
Fundamental Index™, the non-capitalization method for creating and weighting of an index of securities, is the patent-pending proprietary intellectual property of Research Affiliates, LLC (Patent Pending. Publ. Nos. US-2005-0171884-A1, US-2006-0015433-A1 and WO 2005/076812).
3 For broker/dealer information only
Why Index?
Access market returns at low cost
Most active managers don’t beat index returns
■ It’s very hard to pick the winning managers (or stocks)
Favorable portfolio attributes
■ Large investment capacity
■ Low fees and expenses
■ Diversification
■ Broad market exposures
4 For broker/dealer information only
Index vs. Active Management: U.S. Market
10 Years 20 Years
S&P 500 Index 9.07% 11.94%
Average Equity Fund* 7.62% 10.54%
S&P 500 Advantage
(percentage points)1.45% 1.40%
*Consists of ALL Lipper equity categories.
Performance data quoted represents past performance and does not indicate future results.
Source: Lipper, Wilshire, and the Vanguard Group. Time periods ending 31 December 2005.
5 For broker/dealer information only
Index vs. Active Management: Global Markets
International
■ 69% of active managers underperformed (241 funds vs. MSCI World)
Europe
■ 86% of active managers underperformed (154 funds vs. MSCI Europe)
Emerging Markets
■ 76% of active managers underperformed (129 funds vs. MSCI Emerging Markets)
Universe: Emerging Markets active equity funds registered in Austria, Belgium, France, Germany, Ireland, Italy, Luxembourg, Portugal, Spain, Switzerland, The Netherlands, United Kingdom, and Offshore.
Time Period: 10 years ending 31 December 2005 for International and Europe; 5 years ending 31 December 2005 for Emerging Markets.
Source: Lipper, MSCI, and the Vanguard Group
6 For broker/dealer information only
Why are Cap-Weighted Indexes So Very Dominant?
The markets are cap-weighted
■ To own a portfolio that mirrors the market, we must cap-weight
Rooted in theory
■ Based on Efficient Market Hypotheses (price efficient in markets)
■ In equilibrium, the cap-weighted market portfolio is optimal
Practical benefits
■ Success of S&P 500 set example for others to follow
■ Inexpensive way to gain exposure to market returns
■ Allocation self-adjusts with price movement
■ Positive attributes: liquidity, capacity, low cost
Empirical performance
■ Vulnerable to pricing bubbles and subsequent corrections
Our Biggest Bets are in Equities –Is Theory Leading Us Astray Here?
8 For broker/dealer information only
The Return Drag of Cap-Weighting
The Efficient Markets Hypothesis
� Price identically equals true fair value for all assets at all times
� Hardly anyone believes this
If price equals true fair value plus or minus an error …
� Overvalued will have higher market capitalization and higher valuation multiples than they should
� This creates the size and value effects
How likely is it that the top ten in market cap and the top ten in true fair value will be the same stocks?
� Some of the top market cap get there through pricing error
� None get there as a consequence of being undervalued!
9 For broker/dealer information only
Source: Research Affiliates
How Much Performance Drag Can You Stand from Owning The Top 10 Stocks?
–37.0%–24.9%–15.9%–3.6%1964 – 2006
–29.4%–17.7%–11.0%–2.9%1926 – 2006
10-Year5-Year3-Year1-Year
By How Much Did the Top 10 Stocks Underperform the Average?
27%30%35%38%1964 – 2006
31%37%40%44%1926 – 2006
10-Year5-Year3-Year1-Year
How Often Did the Top 10 Stocks in the S&P 500 Outperform the Average Stock (S&P 500 EW) in the Years that Followed?
10 For broker/dealer information only
Problems with Cap IndexesProblems with Cap Indexes
Introduces substantial growth bias
Fully participates in every market bubble
Fully participates in every market decline
Stocks selected by a committee (S&P, MSCI)
■ Or by formulas which are closely-guarded secrets
Most turnover is in the smallest names
But the most important problem—
Over weights all over priced stocks
Under weights all under priced stocks
Can We Improve on Cap-Weighting?
12 For broker/dealer information only
The Fundamental Index™ Concept
Main Street uses fundamentals:■ Income or cash flow
■ Sales or revenues
■ Book equity value (shareholders’ equity)
■ Gross dividends paid
Creating an index based on “fundamentals”■ An equity index of 1000 stocks
■ Companies selected by fundamentals
■ Companies ranked by fundamentals
■ Companies weighted by fundamentals
This a valuation-indifferent index■ Strips away linkage between portfolio weight and any
over- or under-valuation
13 For broker/dealer information only
RAFI Outperforms with Lower Volatility
Results are based on RA research. Hypothetical or simulated performance results have certain inherent limitations. Unlike actual performance records, simulated results do not represent actual trading.
Source: Bloomberg and Research Affiliates, LLC.
1962–2006
Ending
Value of $1
Annual
Return Volatility Sharpe Ratio
Excess Return vs.
Cap 1000
Excess
Return
t -statistic
S&P 500 85 10.38% 14.74% 0.37 0.08% 0.31
Cap 1000 82 10.30% 14.95% 0.36 0.00% —
Book 177 12.19% 14.64% 0.48 1.89% 3.63
Cash Flow 207 12.59% 14.65% 0.51 2.28% 3.96
Sales 240 12.95% 15.53% 0.51 2.65% 3.67
Gross Dividend 166 12.04% 13.39% 0.50 1.73% 2.25
RAFI™ Composite 201 12.50% 14.48% 0.51 2.20% 3.66
14 For broker/dealer information only
US Fundamental Index 1000 vs. Cap Weighted US 1000
$0
$20
$40
$60
$80
$100
$120
$140
$160
$180
$200
$220
Dec-61 Dec-70 Dec-79 Dec-88 Dec-97 Dec-06
RAFI™ US 1000 Cap Weighted US 1000
Comparison of Indexes
15 For broker/dealer information onlySource: Research Affiliates, LLC
RAFI™ vs. Reference Cap 1000: Rolling 5-Year Annualized Returns
For the period 12/31/1966 – 12/31/2006
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
-10% -5% 0% 5% 10% 15% 20% 25% 30% 35%
Reference Cap 1000 - Rolling 5 Year Return
RA
FI -
Ro
llin
g 5
Year
Retu
rn
16 For broker/dealer information only
Fundamental Index Concept: “Next 2000”
Adds twice as much value as R2V, despite only one-fourth the value tilt.
Source: Research Affiliates, LLC.
Composition andSector Allocation Stability
18 For broker/dealer information only
Twenty Largest Holdings on 12 / 31 / 2006Twenty Largest Holdings on 12 / 31 / 2006
Company Weight Company Weight
1 Exxon Mobil Corp 2.95% 1 Exxon Mobil Corp 3.26%2 General Electric 2.53% 2 General Electric Co 2.72%3 Citigroup 2.11% 3 Citigroup Inc 1.95%4 Microsoft Corp 1.68% 4 Microsoft Corp 1.87%5 Bank of America 1.65% 5 Bank of America Corp 1.72%6 Chevron 1.61% 6 Procter & Gamble Co 1.49%7 JPMorgan Chase & Co 1.49% 7 Johnson & Johnson 1.38%8 General Motors Corp 1.48% 8 Pfizer Inc 1.34%9 Altria Group 1.43% 9 Altria Group Inc 1.26%
10 AT&T 1.40% 10 JPMorgan Chase & Co 1.18%11 Verizon Communications 1.35% 11 Cisco Systems Inc 1.18%12 Wal-Mart Stores 1.33% 12 Chevron Corp 1.15%13 Pfizer 1.08% 13 American International Group Inc 1.11%14 Berkshire Hathaway 1.01% 14 IBM Corp 1.06%15 American Intl Group 0.92% 15 AT&T Inc 0.98%16 Merck & Co 0.92% 16 Wells Fargo & Co 0.84%17 Ford Motor 0.88% 17 ConocoPhillips 0.84%18 Johnson & Johnson 0.83% 18 Intel Corp 0.83%19 International Bus Machns. 0.82% 19 Hewlett-Packard Co 0.81%20 Wells Fargo & Company 0.77% 20 Wal-Mart Stores Inc 0.80%
Russell 1000FTSE RAFI 1000
Source: Research Affiliates, LLC
19 For broker/dealer information only
Rotation in the Top 10, Cap Weighted
CAP WEIGHTING, TOP 10 LISTS, 1/1965-1/2007
Rank Jan-65 Jan-70 Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-07 Fallen Angels
1 T/SBC IBM T/SBC IBM IBM XON/XOM GE MSFT GE XOM 26
2 GM T/SBC IBM T/SBC XON/XOM GE T GE XOM GE Changes:
3 J/XOM GM J/XOM XON/XOM GE IBM XON/XOM CSCO C C 30
4 IBM EK EK GM GM T/SBC KO WMT MSFT MSFT Flip/Flops:
5 TX/CVX J/XOM GM SN/AN T/SBC MO MO XOM PFE BAC 15
6 DD S S MOB/XOM SUO MRK WMT INTC BAC PG Leads RAFI:
7 S TX/CVX PG GE SN/AN BMY MRK LU JNJ JNJ 23
8 GE XRX GE SD/CVX DD DD IBM IBM IBM PFE Lags RAFI:
9 GO/CVX GE SN/AN ARC/AN S SN/AN PG C AIG MO 41
10 EK GO/CVX TX/CVX SUO EK BLS DD AOL INTC JPM
Green = New to top 10 Red = Falling off top 10 Blue = Flip/Flop
Source: Research Affiliates, LLC
20 For broker/dealer information only
Rotation in the Top 10, RAFI
FUNDAMENTAL INDEXING, TOP 10 LISTS, 1/1965-1/2007
Rank Jan-65 Jan-70 Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-07 Fallen Angels
1 GM T/SBC T/SBC T/SBC T/SBC XON/XOM XON/XOM XOM XOM XOM 10
2 T/SBC GM GM GM XON/XOM IBM IBM F C GE Changes:
3 J/XOM J/XOM J/XOM XON/XOM IBM GM GM GE GE C 17
4 F F IBM IBM GM F F GM WMT MSFT Flip/Flops:
5 TX/CVX IBM TX/CVX MOB/XOM MOB/XOM T/SBC GE C FNM BAC 2
6 DD TX/CVX F F TX/CVX MOB/XOM T/SBC T/SBC BAC WMT Leads CAP:
7 GE GO/CVX GO/CVX TX/CVX SN/AN GE MOB/XOM MO T/SBC VZ 41
8 S MOB/XOM MOB/XOM GE CHV/CVX DD MO FNM CVX CVX Lags CAP:
9 IBM GE SD/CVX GO/CVX GE CHV/CVX DD WCOM GM MO 23
10 SD/CVX S S SD/CVX DD SN/AN CHV/CVX IBM AIG PFE
Green = New to top 10 Red = Falling off top 10 Blue = Flip/Flop
Source: Research Affiliates, LLC
21 For broker/dealer information only
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006
Po
rtfo
lio
Co
mp
osit
ion
- C
ap
Weig
hte
d
Retail
Non-Dur
Chem
Health
Finance
Energy
Dur
Manu
Elec. Eq.
Telcom
Util
Other
Sector Weights Over Time,Capitalization Weighting
Source: Research Affiliates, LLC
22 For broker/dealer information only
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006
Po
rtfo
lio
Co
mp
osit
ion
- R
AF
I
Retail
Non-Dur
Chem
Health
Finance
Energy
Dur
Manu
Elec. Eq.
Telcom
Util
Other
Sector Weights Over Time,Fundamental (Composite) Weighting
Source: Research Affiliates, LLC
How Well Does the Fundamental Index™ Concept
Work Outside of the US?
24 For broker/dealer information only
Fundamental Index™ International1983-2006 Cumulative Performance
$0.0
$5.0
$10.0
$15.0
$20.0
$25.0
$30.0
Dec-83 Dec-85 Dec-87 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05
RAFI™ International FTSE All World ex US FTSE All World ex US Value
Source: Research Affiliates, LLC
25 For broker/dealer information only
How Well Does Fundamental Index™ Work Globally?
Source: Research Affiliates, LLC
Country
RAFI™
Return
MSCI
Return
Excess
Return
Tracking
Error Info Ratio
Excess
Return t-
stat
Start
Date
Ireland 20.1% 12.1% 8.1% 8.48% 0.95 4.15 1988
Austria 18.4% 13.5% 4.9% 8.87% 0.56 2.67 1984
Norway 17.7% 13.2% 4.6% 6.08% 0.75 3.61 1984
France 17.3% 13.4% 3.9% 6.72% 0.59 2.81 1984
Singapore 12.8% 9.0% 3.7% 6.09% 0.61 2.68 1988Portugal 12.5% 9.1% 3.5% 7.91% 0.44 1.86 1989Spain 17.2% 13.8% 3.4% 4.82% 0.72 3.13 1988Hong Kong 21.0% 17.6% 3.4% 5.80% 0.59 2.81 1984
United Kingdom 15.3% 12.3% 3.0% 4.12% 0.73 3.50 1984Germany 13.4% 10.4% 3.0% 5.62% 0.53 2.55 1984Canada 13.7% 10.7% 3.0% 6.54% 0.45 2.17 1984
Japan 7.9% 5.0% 2.9% 5.21% 0.56 2.68 1984
United States 13.7% 10.8% 2.9% 4.51% 0.64 3.06 1970Italy 16.3% 13.9% 2.4% 5.27% 0.45 2.15 1984Australia 16.0% 13.7% 2.2% 4.90% 0.45 2.18 1984Greece 22.0% 19.9% 2.1% 7.40% 0.28 1.21 1989Sweden 18.0% 16.0% 2.1% 9.40% 0.22 1.05 1984Denmark 13.0% 11.1% 1.9% 7.78% 0.25 1.18 1984
Finland 15.6% 13.8% 1.8% 20.70% 0.09 0.39 1988
Belgium 16.7% 15.3% 1.4% 5.03% 0.27 1.31 1984
Netherlands 14.0% 13.0% 1.1% 6.04% 0.18 0.86 1984
New Zealand 7.6% 7.2% 0.4% 8.48% 0.05 0.20 1988
Switzerland 12.2% 12.6% -0.4% 4.06% -0.10 -0.48 198423-Country Average 14.9% 11.8% 3.1% 2.67% 1.17 5.64 1984
23 Country Return Statistics through December 2006
26 For broker/dealer information only
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
-10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40%
Other Developed Other G6 United States
For Cap Returns > 30%,
RAFI™ adds value in
41% of all cases
For Cap Return 20-30%,
RAFI™ adds value in 63%
For Cap Return 10-20%,
RAFI™ adds value in 76%
For Cap Return 0-10%,
RAFI™ adds value in 85%
of all cases
For Cap Return < 0%,
RAFI™ adds value in 97%
of all cases
RAFI™ vs. Reference CapRolling 5-Year Returns, 23 Countries
Source: Research Affiliates, LLC
27 For broker/dealer information only
Fundamental Index™ Japan1983-2006 Cumulative Performance
$0.0
$1.0
$2.0
$3.0
$4.0
$5.0
$6.0
Dec-83 Dec-85 Dec-87 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05
RAFI™ Japan FTSE Japan FTSE Japan Value
Source: Research Affiliates, LLC
28 For broker/dealer information only
RAFI Asia ex Japan Performance
Cumulative Performance of $1 Invested in 1989
Just Another Value Index?
30 For broker/dealer information only
Dynamic Attribution Analysis of RAFI Returns
RAFI International (1984-June 2007) RAFI 1000 (1962-June 2007)
Total Value Added 3.50% Total Value Added 2.12%
Sector Allocation 0.33% Sector Allocation 0.50%
Static Value Added -0.02% Static Value Added -0.05%
Dynamic Value Added 0.35% Dynamic Value Added 0.54%
Value Tilt 1.68% Value Tilt 1.03%
Static Value Added 0.98% Static Value Added 0.53%
Dynamic Value Added 0.71% Dynamic Value Added 0.50%
Size Tilt 0.46% Size Tilt 0.33%
Static Value Added 0.24% Static Value Added 0.13%
Dynamic Value Added 0.22% Dynamic Value Added 0.20%
Stock Selection 0.22% Stock Selection 0.26%
Country Allocation 0.80%
Static Value Added 0.19%
Dynamic Value Added 0.62%
31 For broker/dealer information only
RAFI Beats Value but Looks Like S&P
Hypothetical or simulated performance results have certain inherent limitations. Unlike actual performance records, simulated results do not represent actual trading.
Source: Bloomberg and Research Affiliates, LLC.
RAFI® 1000 vs S&P 500 and Russell 1000 Value
(1979-June 2007)
0
10
20
30
40
50
60
70
Jan-79 Jan-84 Jan-89 Jan-94 Jan-99 Jan-04
RAFI® 1000 S&P 500 Russell 1000 Value
Return Volatility
Value
Add Beta Correl
RAFI® 1000 15.7% 14.1% 2.3% 0.92 0.96Russell 1000 Value 14.4% 13.8% 1.0% 0.88 0.94
S&P 500 13.4% 14.8%
32 For broker/dealer information only
RAFI Exposure to Value is Dynamic
Value Tilt of RAFI US Large is Most Pronounced When Value is Beating Growth, and Modest When Growth is Beating Value
Value Tilt–Rolling regression coefficient of RAFI US Large against [Russell 1000 Value minus Russell 1000 Growth]/2
Source: Bloomberg and Research Affiliates, LLC.
0.25
0.50
0.75
1.00
1.25
1.50
Jan-79 Jan-81 Jan-83 Jan-85 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07
0.25
0.50
0.75
1.00
1.25
1.50
10-Year Growth vs Value Relative Performance, Left Scale RAFI™ Value Tilt vs Russell 1000 Value Index, Right Scale
How Well Does the Fundamental Indexing™ Concept Work in
the “Less Price Efficient” Space?
34 For broker/dealer information only
Fundamental Index™ Emerging Markets1987-2005 Cumulative Performance
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05
RAFI EM USD FTSE AW EMG FTSE EM Value *
Adds 1000 bp per annum, despite the fact that value hasn’t worked in EM.
35 For broker/dealer information only
Are We Blinded by Theory?
Theory does a Marvelous Job explaining how the world ought to work
Theories are sometimes provable, based on certain assumptions
Gaps between theory and reality are normal
Still, some observers cling to theory as fact
■ Assume a theory is correct description of reality
■ Assume that, therefore, the assumptions are correct
■ This is exactly backwards!
36 For broker/dealer information only
Enough of the Past …How about the Future?
Paul Samuelson:
“Only the smallest fraction of economic writings, theoretical and applied, has been concerned with the derivation of operationally meaningful theorems. In part at least, this has been the result of the bad preconception that economic laws deduced from a priori assumptions possessed rigor and validity independently of any empirical human behavior. But only very few economists have gone so far as this. The majority would have been glad to enunciate meaningful theorems if any had occurred to them.”
1. Theory is not fact. It describes an ideal world.
2. Empirical data which contradicts theory may be right.
3. Theory is improved by acknowledging its flaws and findingimprovement, not by rejecting contradictory evidence.