God is a Capitalist

Thursday, June 2, 2016

Fundamentalist investing scores big gains

Last week I wrote about fundamentalism and I want to carry on with that theme this week. I’m late to the party. Research Affiliates launched their fundamental indexes over ten years ago, but I only recently read The Fundamental Index: A Better Way to Invest by Robert Arnott, Jason Hsu and John West.

The authors promote index investing because of the evidence of the failure of most active managers to match the percentage returns of indexes such as the S&P 500. For most part time investors, indexes are the best choice. Even Warren Buffet enlisted an index fund to sustain his wife’s wealth after he moves on.
As I wrote in Financial Bull Riding, percentage returns are not the appropriate measure of performance. Absolute dollar returns are. That’s because most investors will not put 100% of their funds in stocks, not even an index ETF or fund. They will hedge for a downturn in stocks by diversifying into other assets, at least bonds. Many will choose something like a 60/40 split between stocks and bonds. When the stock market does well, bonds won’t and that drags down the percentage returns. But in a bear market the bonds support the sickly stocks and reduce losses. As a result, the average percentage returns on investments may be worse than the index, but the corralling of losses in bear markets can make absolute returns much greater than what would have been achieved in a portfolio fully invested in stocks with a higher percentage return. It's counter intuitive, but the math bears it out. I give examples in Financial Bull Riding.

The point is that if you are diversified across at least two asset types, it’s impossible to match the percentage returns in a bull stock market. Insurance against a downturn will cost you, but it pays handsome rewards in a bear market.

The Fundamental Index improves on the typical index because they are usually cap weighted. That means the creators of the indexes start with the market capitalization of each stock (price times outstanding number of shares) and divide it by the total market capitalization. As the authors point out, that puts the index investor in the mode of chasing growth stocks. Those stocks that have risen the most in price get a higher allocation while those suffering price declines get a reduction in weight in the index. It’s the opposite of value investing.

Instead, the Fundamental Index (FI) weights the allocation of stocks according to sales, profits, dividends and book value. It adjusts for companies that don’t pay dividends. Consequently, the allocation in the index increases only if the fundamentals of the company improve but not if only the price rises. Over the 40-year period covered by the back testing, the FI outperforms the S&P 500 by about 2% per year, which adds up to a much greater absolute return after compounding for several decades.

One of the most interesting features of the FI would have been its behavior during the massive bubble of the late 1990s. The FI would have risen more slowly than the S&P 500 and never reached its heights, but as the S&P 500 was collapsing in 2001 by 40% the FI would have continued rising and eventually reached the record height the S&P 500 set in 2000. The FI eventually declined about 18%. Again, the smaller decline in the index during the bear market more than made up for the slow rise during the bull.

The authors expanded the concept to include large, small, value, and foreign stocks as well as a bond index. The alpha performance of the indexes grows dramatically with foreign stocks where PE ratios can get far out of line.

Investors who find index investing appealing but can tolerate greater risk might want to borrow to buy more of the index and boost returns. But the investor will want to watch the business cycle closely and get out of stocks before a recession and bear market in order to avoid the losses. 

The authors exhaust a lot of real estate in the book trashing the Efficient Market Hypothesis. I don't have a dog in that fight, though. I see the EMH and behavioral investing both being right, just at different times. The EMH takes a very long view of the market while the behavioral perspective is very short run. Behavioral theory merely explains the divergences and anomalies in the data that EMH can't.

I couldn't help but wonder while reading the book, if the FI can improve returns so much, why stop with just allocating purchases according to company fundamentals? Why not use other fundamental measures, such as cash flow, to pick the best companies in a group as Joel Greenblatt has done, or as the many indexes in the American Association of Individual Investors (AAII) do? After all, one of the reasons for the success of indexes is that they take most of the emotion out of investing and force the investor to follow sound rules for allocating funds in a portfolio.
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