The Fundamental Index: A Better Way to Invest

by Robert D. Arnott, Jason C. Hsu, John M. West

2008 American Publishers Awards for Professional and Scholarly Excellence (The PROSE Awards) Finalist/Honorable mention, Business, Finance & Management. The Fundamental Index examines a new approach to indexing that can overcome the structural return drag created by traditional capitalization-based indexing strategies, and in so doing, enhance the performance of your portfolio. Throughout this book, Robert Arnott and his colleagues outline this breakthrough strategy and explain how it can be used to improve investment returns, typically at lower risk and lower cost than most conventional investments.

Genres: Finance

471 pages, Kindle Edition

First published April 1, 2008

About the author

Robert D. Arnott is a leading industry thinker and researcher who served as the editor of the Financial Analysts Journal from 2002–2006 and who has authored over 100 articles for journals such as the Financial Analysts Journal, the Journal of Portfolio Management, and the Harvard Business Review. Arnott serves as Chairman of Research Affiliates, LLC, a global leader in innovative investing and asset allocation strategies. Founded in 2002, Research Affiliates distributes investment products in partnerships with leading financial institutions including PIMCO, PowerShares, Charles Schwab, Nomura Asset Management, and FTSE, to name only a few.

Reviews

[Michael Cestas · Rating 3 out of 5]

The main idea of the book is simple and compelling: *IF* markets are not efficient (or very, very close to it) then any index weighted by market cap systematically overweights overvalued stocks and underweights undervalued stocks. If you further believe that prices track intrinsic value over time, then cap weighted indexes suffer a performance drag over time, as price errors correct.

The proposed solution is to weight index components by a measure that is not linked to market cap. More specifically, the authors propose linking weights to fundemental measures, like sales, or a composite of metrics like sales, profitability, etc.

The book includes numerous examples demonstrating the superior performance of this suggestion by examining backtests in different geographies and different market cap ranges.

The main drawback of the book is that it is a book. In reality, it is a good essay, or article, or blog post, masquerading as a book. Once you grasp the key message you are safe to put the book down, or skip to the charts if you want to study the backtests.

[Robert]

This is basically a very large brochure for the Research Affiliates Fundamental Index products. I read it to do due diligence before investing in some products that track their indices. However I really feel that this material should be free for consumers/investors, so I picked this up at my library. I found the arguments presented in this book convincing and now use some RAFI ETFs.

[Jim · Rating 4 out of 5]

It's mostly a 200+ page sales pitch, but the arguments are convincing, though the writing is repetitive and jargon-filled. Unfortunately, the "product" is not available at the low costs that it should be as a passive investment choice.

[Ajay · Rating 4 out of 5]

First off- this book was at least 2x as long as it needed to be, at a certain point it became fairly repetitive.

As for the substance: The basic thesis of this book- that the cap weighted index's greatest flaw is that is that it is linked to the price of the stock (i.e. if a company turns out to be overvalued it will have overweighted it today, and if it was undervalued it will hold less, is a drag on returns), I had already started to come around to (It seems to me that to a certain extent the point of diversification is to mitigate large cap growth blowups at the end of a bull market). I also really liked that whenever I started to wonder about how fundamental tied into _____, Arnott and company usually addressed whatever I was wondering about in short order (most fascinating to me- I started wondering about the underperformance of the existing fundamental indices relative to the cap weighted indices, and shortly thereafter, it predicted that it would underform in the kind of recent bull market we just had (This book was published in 2008, well before the most recent bull cycle started).

However, I'm not entirely convinced that Arnott and company didn't just rediscover the HML and SMB factors, and if that is all they're doing. you can achieve a similar effect by owning the total market fund of your choice and tilting to taste w/ a SCV index, at a lower cost (Relatedly, the book makes it sound like what they're doing is fairly straight forward, I'm not clear on why the ETF's are so pricey).

[justsomeguy · Rating 5 out of 5]

I purchased this book as I knew of Mr. Arnott and his ideas are unique. It is somewhat of a sales pitch but there’s a lot of thought, good charts, and good math going into it.

Interestingly, my takeaway was that markets are pretty efficient already, but a fundamental index would be a good choice for many investors.

[Raj Rajkumar · Rating 5 out of 5]

Provides excellent background on how indexes were developed, criteria for developing indexes, and the rationale for looking beyond market capitalization weighted indexes. A very readable and informative book for all investors interested in passive or index-based investing.

[Dave · Rating 3 out of 5]

Very interesting concept but the book could have been 100 pages instead of 250.