The Fundamental Index: A Better Way to Invest | 
 enlarge | Authors: Robert D. Arnott, Jason C. Hsu, John M. West
Creator: Harry M. Markowitz
Publisher: Wiley
Category: Book
List Price: $29.95
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Avg. Customer Rating:  11 reviews
Sales Rank: 20496
Media: Hardcover
Number Of Items: 1
Pages: 336
Shipping Weight (lbs): 1.2
Dimensions (in): 9.1 x 6 x 1.3
ISBN: 047027784X
Dewey Decimal Number: 332.6
EAN: 9780470277843
ASIN: 047027784X
Publication Date: April 25, 2008
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Condition: hardcover 1st ed. 1st prt. Wiley 2008
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Product Description
The Fundamental Index offers a breakthrough strategy for capturing the best market returns at the lowest cost and with the least risk. In this important new book, the highly respected Rob Arnott explains how passive, market capitalization weighted index investing falls short and fails to serve investors, investing too much in overpriced stocks and too little in underpriced shares. He shows how a new twist on indexing, fundamental indexing, eliminates this return drag and, in so doing, earns greater returns. In addition to discussing the powerful long-term performance of this strategy, this comprehensive guide also reveals how the new fundamental index outperforms most powerfully when excess returns are needed most, during market and economic downturns. In short, Arnott's innovative and straightforward strategy gives investors a new tool to achieve excess returns in a projected low-return environment while preserving the many positive attributes of index fund investing.
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| Customer Reviews: Read 6 more reviews...
 Past performance is no guarantee of future one July 20, 2008
This book written by the strongest advocate practitioner (Arnott) of Fundamental Indexing (FI) is well written. But, you should not confuse a FI manifesto for a balanced analysis on FI vs Market Cap Indexing (MCI). Arnott goes as far as stating that FI has redefined the entire investment Efficiency Frontier (pg. 241) as for any level of risk, he believes FI earns a higher return. And, for any level of return FI reduces your risk. To his credit, Arnott does a good job of addressing the main critiques against FI in chapters 10 and 11. However, for more challenging FI rebuttals, I recommend the articles by Paul Kaplan and Andre Perold.
The logical advantage of FI is unclear. In the Foreword, Harry Markowitz makes an example with a two stock portfolio and shows how stock mispricing will cause MCI to be over weighted in the overpriced stock. When such a stock reverts back to its fair value, MCI suffers a return drag vs FI. But, Andre Perold using Bayesian analysis, takes apart this exact same example because you don't know beforehand which stock is over valued. To further confuse things, Arnott early in the book (page 38) contradicts himself. He states that a MC index does not have a negative Alpha. But, capitalization weighting does. That's not possible. Either they both incur negative Alpha, or they don't (besides the minor cost difference). Later, on page 208 according to his own analysis, Arnott recognizes that with large caps only 1/3 of the FI value added comes from its actual structure. The other 2/3 come from small cap and value tilts.
To clarify this issue, I will review: a) what I expect the difference between FI and MCI to be, b) the historical records, and c) the FI outlook.
Because FI is under weighing growth stocks, I expect it outperforms during Bear markets and underperforms during Bull markets. Because Bull markets are much longer than Bear ones, I expect FI to earn lower returns but with lower volatility. On a risk-adjusted basis the two should earn equivalent returns. When factoring FI higher turnover resulting in higher operating costs and taxes, MCI should come out slightly ahead.
FI historical back tested records are very impressive. Contrary to my expectation, over the 1962 to 2007 period FI outperformed MCI in Bull markets (by a small margin). And it killed MCI by several percentage points in Bear markets. Overall, FI beats MCI by 2 percentage points p.a. (for large cap) while incurring the same risk (same standard deviation). FI beats the MCI for just about any segment of the equities market: large cap, small cap, value, growth, international, country specific (pg. 123), emerging markets, and REIT. The FI advantage increases from 2% to up to 6% as you move into less efficient markets such as emerging markets. Such historical results are not entirely explained simply by FI smaller cap and value tilt. Any higher return is usually associated with much higher risk (but not for FI). Also, FI beats MCI when focusing on either value or small cap stocks only. Thus, something is going on besides small cap value tilt. Arnott states FI superiority is due to the inefficient allocation of MCI that overweighs the growth stocks that suffer the worst returns in Bear markets. But, FI under weights this same growth stocks during Bull markets. What the FI gains during Bear markets, it should give back during Bull markets. But, it did not. It beat the MCI during Bull markets too. The few times the FI fell behind is during short bubbles such as the late 90s dot.com bubble.
Actual live performance of FI funds has been so far not impressive. This contradicts the author's assertion on page 176. That's because my data set extends another 7 months since the book was published. I investigated the two RAFI funds with available public records: RAFI US 1000 (PRF) covering large caps started in December 2005 and RAFI US 1500 (PRFZ) covering smaller firms. The funds history is short, but is a good test as it captures a Bear Market that started in May 2007. Thus, I would expect the RAFI funds to do better than their MC index fund counterparts. I compared PRF and PRFZ with the traditional index funds most correlated with them, respectively Vanguard Large Cap Value (VIVAX) and Vanguard Small Cap Value Index (VISVX). Since inception the RAFI funds have earned the same return (essentially zero) while incurring the same volatility vs their traditional index counterparts. Since May 2007 (beginning of Bear Market), PRF return is - 23.1% vs - 22.7% for VIVAX. (PRF did a bit worst than VIVAX). Meanwhile PRFZ return is - 20.3% vs - 21.9% for VISVX. (PRFZ did better than VISVX). In both cases, those RAFI funds way underperformed a plain total stock market index fund, especially in a Bear market. This short term track record, especially in a Bear market that should favor RAFI funds, does not give you confidence that such funds will duplicate the impressive historical back tested record.
Paul Kaplan suggests already the next step: MCI with boundaries delineated by certain multiple of fundamentals. He calls this a collared index. When a specific stock would bubble its weight within the portfolio would be reduced by the delineated fundamentals boundaries. By doing so you would preserve the advantages of MCI (low cost, diversification) while avoiding excessive concentration in over heating stocks (FI advantage). I hope Kaplan puts this concept into practice.
If you find this book interesting, I recommend the following books that also defy existing investment theory: Market Volatility, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, and The Misbehavior of Markets: A Fractal View of Risk, Ruin & Reward. If you want to better understand what traditional investment indexing is about, I recommend the classic A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, Ninth Edition.
 Fundamental Indexing is Active Management, Not Indexing July 1, 2008
First of all, a market portfolio is holding capitalization-weighted stocks. So when Arnott says his "fundamental indexing" beats a cap-weighted portfolio (like on p. 160), he's simply making the same argument active managers make when they say they can beat the market.
It's important to note too that a fundamental index is only a fundamental index once per quarter. These things don't rebalance daily, folks. Even with quarterly rebalancing though, the turnover is higher than with cap-weighted index funds or ETFs. So that's one cost that fundamental indexing must overcome.
The other thing to point out is merely with the fact that more oversight and work is required on the part of the fund company, the expense ratio will be higher than a completely passive cap-weighted index fund. Are the higher fees worth the bet you're making on this strategy?
If markets are truly efficient, then cap weighting is the way to get the market rate of return. Anything else is almost by definition an active or quant (which is what fundamental indexing is) bet.
Your best bet as an investor is to skip the hype and go for the market rate of return.
With all that said, I do still recommend this book to further your investment education. I give it 4 stars out of 5.
 Simple, yet powerful - or Simple, thus powerful? June 30, 2008
I believe the book is a must read for professional investors as well as non-professionals, advisors, trustees and most certainly the academic community. It offers a (deceptively) simple explanation to a series of widely debated issues in modern portfolio construction. While I wouldn't dare entering into a debate with any of the rather well-known critics of the concepts I would propose that they all read the book carefully and contemplate the principle known as Occam's razor while doing so; "Occam's razor (sometimes spelled Ockham's razor) is a principle attributed to the 14th-century English logician and Franciscan friar William of Ockham. The principle states that the explanation of any phenomenon should make as few assumptions as possible, eliminating those that make no difference in the observable predictions of the explanatory hypothesis or theory." (Quote from Wikipedia) The Fundamental Index concept as such may not be new, other will have to be the judge of that, but at least I know of no other formalization of the concept, nor of any other text offering the richness in its explanations of the sources and applications of the concept. (Disclosure: I am on record as being a supporter of the concept and I work for a firm that is a Research Affiliates, LLC, licensee.)
A balanced comment on FI May 30, 2008
8 out of 9 found this review helpful
Watch Video Here: http://www.amazon.com/review/R13S4FN7LU8QHY
An Excellent Overview May 26, 2008
3 out of 3 found this review helpful
This book contains a good overview of the basic arguments for and against The Fundamental Index in a very readable format. For those who have followed the debate in the finance journals, there will be little new here and the book does not address the formal mathematical models of Fundamental Indexing that have been introduced in various papers from Arnott & Hsu. However, the data and arguments are well organized, with the book proceeding from an introduction of the concept, through the historical data and ending with a balanced overview of the arguments for and against.
The book is more than just a pitch for a particular investment strategy, the issues raised in The Fundamental Index touch upon the empirical foundations (or lack thereof) of Modern Portfolio Theory and will force any investor, regardless of whether they use the approach or not, to think more carefully about their basic assumptions about the equity markets.
For a layperson looking for depth and insight into the equity markets, this book would make an excellent supplement to a more general work such as Burton Malkiel's Random Walk Down Wall Street.
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