In his latest interview on the Masters In Business Podcast, Rob Arnott discussed development of his ‘fundamental index’ and why “rebalancing alpha is the dominant engine in incremental returns”. Here’s an excerpt from the interview:
Arnott: And so, we developed the idea of fundamental index which has become a very important part of our business. It’s over 140 billion in assets now and it’s under license to other distribution partners, PIMCO, Schwab, Invesco, Nomura and the list goes on and on. We have at least eight-part distribution partners with at least 10 billion each, managed using our ideas.
So, what is cool about fundamental index is that you’re earning a profit based on two things. First, the obvious one, a value tilt. If growth stock is priced at lofty multiples to fundamentals, then you’re reweighting those stocks down to their economic footprint, the size of the business and if a stock is trading at deep discounts, you’re reweighting it up, so you have a stark value tilt all the time and value investing usually wins.
But it turns out that’s not the dominant source of incremental return. It turns out that the dominant source of excess return is a rebalancing discipline. If a stock soars and the fundamentals don’t, then RAFI, the fundamental index, will say thank you for the lovely gains. Let’s reweight this investment down to its economic footprint.
And if this company tumbles and its fundamentals, don’t RAFI will say, thanks for the lovely discount. Let’s reweight you back up to our economic footprint. So, since the market is constantly changing its mind, as to how much a company is worth, you’re constantly rebalancing contra trading against the markets most extravagant bets and your biggest bets will be on the companies where the market is making the biggest bet in the opposite direction.
The companies that have soared the most, GameStop, tremendously this quarter on top of an already stupendous rise in 2020. So, you’d look at that and if you owned it, which we did, we owned it as a value investment with a cost basis of around a little under four bucks a share, if you owned it, you’d say thanks for this great gain, the underlying fundamentals haven’t changed, let’s take some profits and rebalance.
That rebalancing alpha is the dominant engine for incremental return and that is not true of most of the strategies that currently carry the smart beta label.
You can listen to the entire interview here:
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