Arnott says that the idea of fundamental indexing wasn’t instantly embraced by everyone. One of the earliest criticisms was that fundamental indexes are a value tilt, something that Arnott doesn’t argue.
“But it’s a special value tilt that’s a dynamic one that contra-trades against the market’s changing views,” he says. “Critics who say it’s just a value tilt – how do they explain that value underperformed 1.4% while RAFI outperformed 2% a year?”
And that wasn’t just in the United States. In fact, fundamental indexes overseas have done even better.
Fundamental indexing isn’t always outperforming, however. When value starts to underperform, fundamental indexes will see performance suffer, as well.
“But when value is winning, we have a tailwind and we win by more,” he says. “You really have to view it over an economic cycle.”
In 2007 and 2008, for example, fundamental indexing did poorly as the broader market suffered. In 2006 and 2009, it did better, while in 2010, value was neutral, though fundamental indexing outperformed 4%.
“It’s a really simple idea that turns out to be pretty darn powerful.”
Who Uses It?
Arnott doesn’t foresee anyone dumping cap-weighted strategies from their portfolios entirely.
Some of his clients have done away with cap-weighting, but they’re in the minority. “Most people how use fundamental indexing currently use it as a complement to classic cap weighting.”
Arnott says the critics have quieted down, too, though they’ll always be there in one form or another, and he’s just fine with that.
“People who will take the other side of our trades? We’re happy to have them.”