By Christopher M. Wright

NAME: Robert Arnott TITLE: Chairman, Research Affiliates, LLC and editor, Financial Analysts Journal BORN: 1954 EXPERIENCE: Arnott graduated summa cum laude from the University of California in 1977. He was an equity strategist at Salomon Brothers and chairman of First Quadrant, LP before founding Research Affiliates LLC in 2002. His firm develops asset management products and software models and offers investment subadvisory services to PIMCO and other clients. He has published more than 70 articles in the Harvard Business Review and academic journals. He has won five Graham and Dodd Scrolls or Awards from the CFA Institute, two Bernstein-Fabozzi/Jacobs-Levy awards from the Journal of Portfolio Management and Institutional Investor and, in 2005, two William F. Sharpe Indexing Achievement Awards for "Best Index-related Research Paper" and "Most Innovative Benchmark Index." He is also a visiting professor of finance at UCLA, editorial board member of three journals including the Journal of Portfolio Management, and product advisory board member of the Chicago Board Options Exchange and two other exchanges.

There's an innovative investment strategy making news—fundamental indexing. It's been dismissed by market luminaries such as John Bogle and Burton Malkiel, but in its corner are PIMCO, Nomura Asset Management, indexer FTSE Group and academic heavyweights Jack Treynor of Treynor Capital Management and Jeremy Siegel of the Wharton School, University of Pennsylvania.

Robert Arnott, chairman of Research Affiliates, LLC and editor of the Financial Analysts Journal, is the financial innovator who first introduced the idea of fundamental indexing. He tells Portfolio why fundamental indexes are attractive investment alternatives and how REITs fit into the picture.

Portfolio: The amount of investor funds linked to capitalization-weighted indexes like the S&P 500 through index funds or benchmarking is estimated to be in the trillions of dollars. What's wrong with cap-weighted indexes?

Arnott: Cap-weighted indexes are great for matching market performance at very low fees. However, people have been complaining since S&P introduced the first cap-weighted index in 1957 that any company trading above its eventual true fair value is going to be overweighted in the index. Any company below its true fair value is going to be underweighted. Cap-weighting doubles exposure to a stock just because its share price has doubled. That's just not sensible.

Portfolio: If the market isn't rewarding fundamentals at the moment, why wouldn't you want to overweight the companies whose values are going up?

Arnott: Admittedly, fundamental indexing will underperform during a speculative, growth-dominated bubble, so it's not for investors who lack patience. However, the trendy and the popular companies already carry a premium in price; that doesn't mean that future price gains from current levels will be large. What you want are companies that will be more popular a year from now. If you start with companies that are highly popular today, you're going into a headwind. A lot of those companies will be less popular a year from now. A cap-weighted index loads you up on growth stocks and trendy stocks, most of which have put their run of performance behind them. They are less likely to deliver the goods in the future and to sufficiently achieve superior growth to justify the high multiples they carry today.

Portfolio: How is fundamental indexing different?

Arnott: Fundamental indexing adds value in the long run because the weights in the portfolio are unrelated to over- or under-valuation, and it pays no attention to price-earnings ratios and other valuation multiples. It ignores fads and bubbles, and instead weighs companies by how big they are in the economy today, not by Wall Street's estimate of the company's size 10 or 20 years from now.

We measure the footprint of a company in today's economy by sales, profits, book value and gross dividends. We use absolute numbers, not per-share ratios, because total dollar sums are the most accurate measures of company size in the broad economy. Then, we average the four weights.

Portfolio: Fundamental indexing is still a passive investment. What advantage does it have over active money managers who try to beat the market with superior stock selection?

Arnott: If you believe the active manager can add at least 2 percent a year over and above a cap-weighted index, great. Otherwise, we have a simple passive index that has been shown to beat the market by 2 percent a year.

Portfolio: Your "2 percent premium" has drawn a lot of comment. It's based on your research results published in the Financial Analysts Journal, showing that fundamental indexing outperformed the cap-weighted S&P 500 and Russell 1000 in the period 1962 to 2004 by about 2 percentage points per year. But this was back testing. The first PowerShares fund based on your methodology launched in December 2005. Are the results enough to draw any conclusions about the fund's performance?

Arnott: It's too short to be definitive, but it certainly is more than supportive of the concept. In the first 10 months of results, we added over 300 basis points net of all costs relative to the S&P 500. This increased the annual premium against the S&P 500 from the 1.97 percent reported in the journal article to 2.1 percent since 1962.

Portfolio: How should investors use fundamental indexing?

Arnott: A fundamental index is a great core portfolio. It's also a great replacement for value strategies. It doesn't exclude growth stocks the way value indexes do. Fundamental indexing tilts toward value stocks, but the degree is always shifting.

When growth performs extraordinarily well—as it did in the late 1990s—a fundamental index takes on a deep value character compared to cap-weighting, which takes on a profound growth tilt. But when value soars, fundamental indexing's value tilt is only very slight. The value tilt in the fundamental index today is only about one-fourth the size of the value tilt in the Russell 1000 Value Index, yet fundamental indexing has outperformed the value index in a value-dominated market. That's pretty startling, and we were surprised to see it.

Portfolio: What do you most want to say to the critics of fundamental indexing?

Arnott: I think this is a really exciting new idea. The critics, for the most part, have a powerful vested interest in the status quo. Passive indexing has a lot of advantages, but people are deeply frustrated with the drawbacks of cap-weighting. You are assuredly going to chase every bubble that comes along. When an idea arrives that fixes the problems but retains the benefits of passive indexing, the critics should at least get their facts right.

The critics say fundamental indexing has a small-cap tilt. It often does have a slight tilt towards smaller-cap companies, but right now it has a large-cap tilt. It only has 10 percent turnover a year whereas cap-weighting has 6 percent a year—that's only the difference between extremely low turnover and almost no turnover. Fundamental indexing has been criticized for high fees, but it relentlessly adds value whereas active management products do not.

Portfolio: Is fundamental indexing an idea that could change the way investors think, or will there always be important cap-weighted indexes?

Arnott: I would consider it a major win if fundamental-weighting has a 10 percent market share in indexing in 10 years.

Portfolio: What do you think about REITs?

Arnott: REITs are a wonderful asset class. They have a good yield and reliable growth in dividend distributions. They tend to have income that grows approximately 1 percent below inflation, which is great because their dividend yield is 2 or 3 percentage points higher than the market. They have a structural long-term alpha that is helpful to investors in the long run. REITs behave like value stocks, so when the value is working very well in the markets, REITs are on a roll.

It's also an arena in which fundamental indexing works well. We've tested the idea and it adds about 1.5 percent a year. That's pretty good, on top of something that already has just about the highest yields and the highest 20-year total returns of any segment of the market.

Portfolio: Where do REITs show up currently in the PowerShares financial sector fund (PRFF)? What advantage does the fund have over other financial sector plays?

Arnott: Fundamental indexing in the financial services sector beats cap-weighting by an average of 3 percent to 4 percent a year, going back about 17 years. That's tremendous. PRFF is a very powerful way to play the financial services markets.

Portfolio: Why were REITs included in a fund that is mostly banks and insurance companies?

Arnott: FTSE Group, the global index provider, categorizes REITs as financial services companies. The REITs in the fund were selected because they have some of the biggest footprints in the financial sector, based on an average of our four fundamental factors—sales, profits, book value and dividends.