ITA Wealth Management

As I continue to read Arnott’s book, I am increasingly impressed with the research by Research Affiliates Fundamental Index (RAFI). Here is an extended quote from the book.

“The first step was to define the focus of our research. We started with the view that capitalization weighting is efficient only if market prices are efficient. We had already long believed that constructing and weighting an index by each company’s scale of business would prove superior to weighting companies by their market capitalization in markets where pricing errors exist. Although Wall Street judges the size of a company by the price of its stock, most business owners quantify the economic scale of their organization by “Main Street” measures, such as annual sales, profits, net assets, or the number of employees. Moreover, when the popular press describes mergers, it rarely mentions the combined market capitalization.”

Using “Main Street” metrics, RAFI examined the Fortune 500 as their rankings are based on annual sales, not market capitalization.

“We found that this sales-weighted approach outperformed the S&P 500 by more than 250 basis points annually over a span of more than 30 years. This was about three times the “alpha” we expected to see. This evidence powerfully supported our suspicion that capitalization weighting is efficient only if the market prices are efficient. We immediately realized that we were on to something important and well worth serious pursuit.”

The key question remains. Will the drag of additional fees added to the PowerShare ETFs be offset by better performance? While historical data is useful, out-of-sample data is the real test. We will continue to look into the concept of Fundamental Indexes over the next few months.

Lowell Herr

Photograph: Art from the Elan Gallery in West Linn, Oregon