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Market Capitalization is the Market and Not RAFI – A Response to Rob Arnott

Market Capitalization is the Market and Not RAFI

Benjamin M. Lavine, CFA, CAIA

As a preview to his scheduled presentation at the upcoming Inside Smart Beta ETF Conference (June 8-9), Rob Arnott, founder and CEO of Research Affiliates, sat down for an interview with Inside ETFs’ John Swolfs. In advocating for his fundamental indexing methodology (“RAFI”), Arnott made some provocative statements I believe warrant a counter-response.

First, a quick overview of the RAFI methodology, or “Fundamental Indexing.” According to Research Affiliates, RAFI seeks to “sever the link between price (market capitalization) and portfolio weights” using alternative, fundamental measures of company value or their “economic footprint.”

The original footprint comprised a company’s sales, cash flow, book value and dividends, but has since evolved to include other measures such as delivered sales, dividends/buybacks and retained cash flow, depending on the index series (FTSE/Russell is the primary index provider for RAFI).

In addition, the RAFI methodology underpinning the PIMCO Fundamental IndexPLUS strategy incorporates net operating assets, debt coverage ratios and buybacks. The impetus for developing RAFI came in response to the late 1990s internet bubble market and its subsequent collapse, which led Arnott to explore other index weighting methodologies that didn’t leave the investor exposed to high-valuation, high-momentum stocks.

However, in reaffirming the case for Fundamental Indexing, Arnott argues that RAFI should serve as the standard for how investors invest in equities rather than market capitalization. In other words, RAFI, rather than market capitalization, should serve as the baseline anchor for equity allocations within an investment program.

Is Market Capitalization Inherently Flawed?

First, Arnott identifies what he believes is a fundamental flaw in market capitalization:

“[Rob Arnott]: While capitalization weighting makes an assumption that market prices are correct, intuitively they’re not. The price of any stock represents its fair value, plus or minus an error. The market may judge the price too high, it may judge it too low. The market is constantly trying to figure out whether the price is too high or too low. In the very long run, the errors are mean-reverting; they correct over time …”

But I would argue the opposite; namely, that market capitalization is intuitively correct, even as it constantly corrects forecasting errors of fair value. At its core, market capitalization encompasses the Wisdom of the Crowds or the aggregate assessment of the fair or intrinsic value of the constituent equities comprising the index.

Dividend discount modeling (or the Gordon Growth model) represents the most basic form of measuring intrinsic value. The model incorporates: 1) the present (or current payout); 2) the future (growth of that payout); and 3) the risk/uncertainty (discount rate) of realizing Nos. 1 and 2. Sure, the model is susceptible to input “error,” but that susceptibility is diminished due to the networking effect of the vast number of amateur and professional participants making such intrinsic value estimates.

Free, diverse and open markets, along with the networking effect, form the basis of efficient market hypotheses. If none of these ingredients were present, then Arnott would have a strong case for proposing an alternative to market capitalization as the baseline for allocating equity capital.

The “crowd” may get it wrong from time to time, but we can only subjectively identify those instances in hindsight, and even those instances may eventually prove correct (witness the rising valuation of Amazon from its 2000-2002 correction).

Assuming Static Valuation

“[Rob Arnott]: If the price of a stock doubles and its weight in the portfolio doubles, then by definition, all else equal, you must be expecting a higher return after the price doubled than before it doubled. You must be expecting a higher return; otherwise, the weight wouldn’t be higher.”

This statement is flawed, because it assumes a static valuation, and that the doubling of price may have very well been a result of cumulative value creation that would leave the stock’s expected return unchanged despite the doubling in price.

In other words, Arnott’s statement assumes that only price moves while the denominator (book value, earnings, cash flow, sales) stays the same (it also falsely assumes that none of the other constituent stock prices are moving).

Market capitalization indexing weights represent the market’s consensus opinion on how the equity should be valued relative to its fundamental metrics. Prices certainly do not move in a vacuum, as implied by Arnott.

Internet Bubble An Outlier

Arnott would presumably argue that there are obvious moments where the entire “market” gets it egregiously wrong (such as the internet bubble); hence, the need for a sounder index methodology that “anchors” constituent weights to more fundamental measures of value, reducing the likelihood of these imbalances from forming in the first place. At the heart of this argument is that market capitalization embodies “performance chasers, the lemmings,” which leads Arnott to “reject cap-weighting.”

But his contention is based really on one episode, the internet bubble, which didn’t pop due to egregiously high valuations, but that the cash for financing eyeball acquisitions eventually ran out.

On the surface, market capitalization appears to result in imbalances or misallocation of equity capital, but we only know of these in hindsight, where it turns out that the sky-high valuations could not support the fundamentals.

The question turns on whether RAFI’s methodology would prevent the sort of imbalances we may observe with market capitalization. We don’t know about the internet bubble, because RAFI was created in response to the bubble.

With respect to the 2008 Great Financial Crisis, to RAFI’s credit, it held a modest overweight to financials (Exhibit 1) heading into the crisis. But then RAFI’s methodology subsequently led it to increase its overweight to financials during the height of the crisis, peaking at over 20% active weight in March 2009 at the depths of the market.

In effect, RAFI turned into a singular, binary bet on the recovery of the financial markets. So, the methodology would have led investors to avoid one kind of sector bet (growth-driven internet technology in 1999) for a different kind of sector bet (value-driven financials in 2008-2009).

RAFI’s methodology is not any less risky than market capitalization. RAFI just takes different kinds of risks—namely contrarian, value-driven risks—and in the extreme, those risks can reach heroic levels that can lead to different kinds of imbalances versus a standard, diversified market portfolio. Its imbalances happen to be more value-driven than growth, momentum-driven.

Exhibit 1: US RAFI Turned into a Singular Bet on the Health of the Financial Sector in 2008-2009

This is not to say that the RAFI perspective on index weighting is flawed, but remember, Arnott is not just arguing for RAFI as providing a valid perspective on investing, but as THE perspective on investing where RAFI should serve as the default for equity allocation as opposed to market capitalization.

RAFI As Active Benchmark?

Further buttressing his contention of the flawed nature of market capitalization, Arnott argues that fundamental indexing should serve as the baseline for judging active management performance.

“[Rob Arnott]: In the early days of fundamental index, we were encouraging people to use it as a benchmark. Our rationale was simple: If you have a dual benchmark, cap weight and fundamental index, you’re going to find that most of your managers fail to beat fundamental index. And you’re going to be drawn toward making greater use of fundamental index, or other smart-beta strategies.

That effort fell flat on its face. Nobody wants a benchmark that’s hard to beat; nobody. So we quickly realized that if you recognized that investors really just want to beat the market, it’s OK; if your benchmark is the market, it’s OK. In addition, you aren’t seeing a push from the factor community to shift the benchmark.”

Relative Risk Exposures

Not every active manager invests like RAFI. Some focus on higher-quality, more profitable stocks that may trade at the market or at a premium to the market. So why should an active manager be measured against an index that has fundamentally different exposures to the manager’s portfolio?

Exhibit 2 displays the estimated relative risk exposures (using Bloomberg’s US Fundamental model) of the PowerShares FTSE RAFI US 100 ETF (PRF) versus the iShares Russell 1000 ETF (IWB) going back to April 30, 2009.

If the line is positive, it means PRF has higher exposure to a particular factor versus IWB and vice versa. The chart shows that RAFI has persistently higher exposures to U.S. value, leverage and volatility, while lower exposures to U.S. profitability.

As for momentum, RAFI has negative exposures over most periods, although there are moments where RAFI looks like the performance-chasing lemming versus the market-cap-weighted index. In effect, RAFI would be more appropriate for benchmarking the performance of value managers as opposed to growth managers—not the ideal candidate for a universal benchmark to measure all active performance against.

Exhibit 2: US RAFI (proxied by PRF) versus Russell 100 (proxied by IWB) – Active Risk Factor Exposures Show RAFI to Have Higher Exposure to Value, Volatility and Leverage versus Cap-Weighting

Despite Mr. Arnott’s claim that market capitalization embodies ‘performance chasing by lemmings’ (or more technically, momentum), the risk characteristics associated with market capitalization are not static but do change over time reflecting the fluidity of market pricing.  And unlike RAFI, market capitalization represents a more objective way of assessing relative value even if there are times when market capitalization is loading up on a single factor like momentum during and after the internet bubble. 

In addition, US RAFI has historically been projected to exhibit higher total risk versus a cap-weighted benchmark as shown in Exhibit 3.  So, Mr. Arnott’s proposed alternative to market capitalization exhibits not only higher risk via value, volatility and leverage exposures but also higher total risk as well. 

Exhibit 3 – RAFI is Inherently Riskier than Cap-Weighting

Why Price Matters

Price tells the investor something not reflected in the “denominator.” RAFI weights a stock based on a company’s sales, cash flow, book value and dividends, but this doesn’t tell you how the company achieved those sales, cash flow, book value and dividends.

Did the company take on more operating and/or financial risk? How effective is the company’s management of investor capital? How sustainable is the operating performance? How cyclical is the operating performance?

Price may not give direct answers to all these questions, but they certainly embed investors’ viewpoints. Price discovery is the lubricant that keeps the market machine from malfunctioning.

Without price discovery, why would a company even bother taking their company public? How would companies be able to monitor in real time the success or failure of their peers? How would investors be able to factor in the impact of an “event” on a company’s valuation?

Price may not be always right, but it can certainly adjust when the “facts change.” So why would anyone deliberately choose to divorce this vital market lubricant from indexing?

RAFI represents one firm’s perspective on how equity capital should be allocated and how its performance should be measured, rather than letting the wisdom of the market determine that. It is less transparent than market capitalization and subject to more changes as Research Affiliates introduces new metrics such as adjusted sales and buybacks.

It is riskier than cap weighting and lacks the price discovery mechanism that helps distinguish one set of economic fundamentals versus another. For these reasons, I doubt RAFI will ever become the standard for setting equity allocations that Research Affiliates is hoping for.

At the time of this writing, 3D Asset Management did not hold PRF, IWM, and PIMCO Fundamental IndexPLUS. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of May 8, 2017, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing sales@3dadvisor.com or visiting 3D’s website atwww.3dadvisor.com.