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September 1st, 2011 by

The New Fundamentally Indexed RALS ETF

Are you a neo-classicist or are you a behavorialist? No, I am not asking you a political question, nor is this a test from you psychology course. It is however the question that Rob Arnott is making us think about. Rob Arnott is no slouch and I recommend we all listen to him. Maybe not necessarily buy (just yet) a new ETF RALS based on his work, but it is certainly worth our attention. Here is why.

Rob Arnott is a major provocateur (it’s a complement) in the finance and portfolio theory research. If you ever heard people debate whether the markets are efficient or not, he would certainly have an opinion about that.

Basically there are finance folks who tell us that the markets are efficient and that the current (i.e. real time) price of any security at any moment is the appropriate price for that particular security at that particular time.

On the other hand the behavorialist believe that markets are inefficient and that we as investors are very human and do not act/behave (i.e. read as buy/sell) rationally, but more according to (taking to it an extreme and how I like to jokingly phrase it sometimes) what we had for breakfast that morning.

What Mr. Arnott’s philosophy is that there is a different way, he is trying to separate noise from the signal and his signal is how well a company is doing based on basic measures such as company sales, cash flow, dividends and book value. It is called fundamental indexing. Mr. Arnott’s company creates indices based on company’s fundamental data, as opposed to market capitalization indices, such as S&P 500 for example.

Does it work? Well the idea makes sense, does it not? You look at companies and you try to figure out certain company measures (or valuation factors) based on which you make an investment decision. Mr. Arnott created a process by taking the largest thousand market capitalization companies and the largest thousand companies according to his company Research Affiliates weightings (the proprietary RAFI index, based on the fundamental company measures such as sales, cash flow, dividends and book value). Having done this exercise he ranks the companies based on RAFI index as compared to the market capitalization weight and ranks the companies. Based on this combination RALS portfolio manager goes long the top twenty percent of the stocks and shorts the bottom twenty percent of the stocks.

What you get is a dollar neutral portfolio that is based on Mr. Arnott’s vision of the world. So what do I do with this, would be a fair question. The answer is not that simple, but certainly worth your consideration.

First of all you have to buy into the fundamental indexing approach, I personally think it is a very innovative one and as it cuts through the efficient/non-efficient market debate. It does not provide a clear answer, but it does provide us with a different perspective. So if you do get beyond this first point and think that this is interesting and makes sense, then there (of course) other considerations.

The idea might be good (and I believe it is), but how is it implemented in real life? The ETF is based on the index and this index is proprietary, so you better trust what’s going on under the hood, as you just don’t know.

The index is reconstituted yearly, which means you hold the same companies, both long and short, for the entire year. And although the dollar neutral position is maintained through monthly rebalancing, I do have a problem with such infrequent index (and hence portfolio) reconstitution.

In my company, having done similar types of quantitative analysis based on the S&P 500 individual companies and corresponding economic sectors I know that company fundamentals that are used in RAFI index (sales, cash flow, dividends and book value) don’t change that much month to month. In fact month to month variation is relatively small. But going over several months, and particularly starting with quarter to quarter the changes in the fundamental measures start to vary. So I question if the yearly index reconstitution is appropriate and might just be too infrequent.

To be fair, it is hard to tell at this stage if this is a success or not, as the ETF just started out and we have to wait and see how it performs. In my opinion the fundamental indexing is a good and an innovative approach and Rob Arnott is brilliant, but I would sit on my money just for now to see how this is implemented.

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