Andrew Hallam
27.03.23

Robert Arnott’s Fundamental Index Packs A Solid Punch
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Book sales are a funny thing. I’ve read several great books that flew below the radar and some mediocre books that became bestsellers. Quality, of course, will always be subjective. But when a wave of interest emerges (whether it’s justified or not) people pile on to surf it. Ask authors and serious fans of the Erotica genre. Most say 50 Shades of Gray was a poorly written book. Goodreads reviewers didn’t disagree. Yet the book broke sales records.

Investment books aren’t as sexy as a lustful billionaire in a kinky room. But The Fundamental Index, by Robert D. Arnott, John M. West and Jason C. Hsu deserves more than a furtive look.

Critics call it a 200 page sales pitch for Research Affiliates. Led by Robert Arnott, Research Affiliates says their fundamental index funds are better than traditional, market-cap weighted indexes.

The Fundamental Index book might not grace your bedside table. But its ideas caught the attention of Vanguard founder John Bogle and the author of A Random Walk DownWall Street, Burton Malkiel.

They didn’t like it.

The late John Bogle believed index funds should hold stocks in proportion to each stock's market capitalization – the market value of all the company's shares.

In contrast, Arnott, Hsu and West believe index funds should comprise a higher weighting in companies with strong financial fundamentals.

For example, imagine two basketball teams. The first team’s coach gives his tallest players the most playing time. This is much like a traditional, cap-weighted index. As companies grow larger, their fortunes or misfortunes have a greater emphasis on how the index performs.

Consider Tesla. In 2021, the company still wasn’t earning high business profits. Its net profits were a fraction of Toyota’s. Yet Tesla was priced higher than all other car manufacturers combined.

Research Affiliates argues that a high emphasis on expensive stocks in an index makes little sense. A fundamental index, for example, would still have included Tesla in 2021. But in basketball coaching terms, Tesla wouldn’t have been given much time on the court. That’s because Tesla’s profits weren’t high enough for it to comprise a large part of a fundamental index.

Instead, the fundamental index coach would have given the most playing time to players with the best shooting, rebound and defensive skills (business profits, dividends and book values)…instead of emphasising height (market capitalisation).

Fundamental indexers also point out that the ten largest companies by market cap in the S&P 500 (think about height) have, as a group, underperformed the market during every rolling 10 year period since 1926.

By emphasizing their holdings based on company cash flow, book value and dividends, fundamental indexes are less likely to fall victim to fads, such as wildly overpriced stocks that almost always, eventually, crash back to Earth.

In their book, Arnott, West and Hsu’s data shows that weighing an index based on company fundamentals beat traditionally weighted indexes in almost every one of the world’s markets between 1984 and 2004 (their book was published in 2008).

In an interview with Morningstar, however, the late John Bogle called the strategy, “Witchcraft.” He said it was more like active management, and expense ratio costs were higher.

Still, fundamental indexes performed much as Research Affiliates said they would during the 2022 market crash. Much like value stock indexes, they weren’t overweighed by popular stocks like Tesla, which ended up crashing hard.

For example, when measuring US stocks, Vanguard’s market-cap weighted S&P 500 index fell 18.23 percent in 2022. Meanwhile, Invesco’s FTSE RAFI US 1000 ETF (PRF), a fundamental index, dropped just 7.80 percent.

In global terms, Vanguard’s FTSE All World ETF (VWRA), a cap-weighted index trading on the London Stock Exchange, plunged 18.11 percent in 2022, measured in USD.

In contrast, Invesco’s FTSE RAFI All World 3000 UCITS ETF, a fundamental index, dropped just 8.71 percent. It trades in USD on the Swiss Exchange, under the symbol PSRW.

Based on the intoxicating popularity of growth stocks over the past dozen years, you might have expected fundamental indexes to be left in the dust (with the exception of 2022). But that wasn’t the case at all.

Vanguard’s Global Stock Market Index (VT) is a traditional, cap-weighted index. A $10,000 investment in January 2011 would have grown to $18,834 by December 31, 2022, measured in USD.

Over the same time period, a $10,000 investment in Invesco’s FTSE RAFI All World 3000 UCITS ETF (PSRW) would have grown to $20,430, in USD, on the Swiss Exchange. The same index trades in GBP on the London Stock Exchange (PSRW) and in Euros on the Frankfurt exchange (PSWD).

Even during times of popular growth for cap-weighted index funds, the fundamental index didn’t disappoint. You can see year-by-year results below.

Maybe, just maybe, the fundamental index isn’t witchcraft after all.

How $10,000 Grew
January 2011 – December 31, 2022

_{* Vanguard’s Global Stock Market Index (VT) trades on the US exchange. I did not backtest its LSE equivalent (VWRA) because it did not exist in 2011.}

Andrew Hallam is a Digital Nomad. He’s the bestselling author Balance: How to Invest and Spend for Happiness, Health and Wealth. He also wrote Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas

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