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At The Money: Looking Beyond Market Cap Weighted Indexes · Masters in Business

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  Speaker 1: Bloomberg Audio studios, podcasts, radio news.
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  Speaker 2: Creations.
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  Speaker 1: Big broad market cap weighted indexes like the S and
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  Speaker 1: P five hundred have dominated investor inflows and performance really
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  Speaker 1: since the Financial crisis, but lately critics of cap waiting
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  Speaker 1: point out that increased market concentration of just a handful
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  Speaker 1: of stocks.
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  Speaker 3: Aka the Magnificent seven is increasing risks for investors. What
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  Speaker 3: should a portfolio manager do about this? Well, to help
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  Speaker 3: us unpack all of this and what it means for
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  Speaker 3: your portfolio, let's bring in Rob are Not, founder of
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  Speaker 3: Research Affiliates and a longstanding critic of market cap weighted indexes.
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  Speaker 3: Raffie runs a variety of fundamental indexes that are based
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  Speaker 3: on things outside of cap weighted. Let's jump right into it, so, Rob,
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  Speaker 3: you've spent decades challenging cap weighted indexes. Is simply just
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  Speaker 3: own more of what just went up. Frame the case
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  Speaker 3: for alternative waiting, regardless of what it is, equal weight,
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  Speaker 3: fundamental whatever versus traditional cap weighting indices.
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  Speaker 2: Let's play a thought experiment. Suppose I came to you
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  Speaker 2: and said, I have a brilliant strategy.
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  Speaker 1: Love it.
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  Speaker 2: This strategy involves watching companies and waiting until their market
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  Speaker 2: value gets above a certain threshold and buying them on average,
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  Speaker 2: I'm buying them when they're up seventy five percent relative
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  Speaker 2: to the market in the last year and trading it
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  Speaker 2: twice the market multiple. Some of these go on to
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  Speaker 2: achieve great success, some don't. And our cell discipline is
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  Speaker 2: very simple. When the market cap falls below a certain threshold,
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  Speaker 2: we're going to sell them, and we'll sell them at
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  Speaker 2: it on average half the market multiple, at a loss
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  Speaker 2: of about seven thousand basis points relative to the market.
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  Speaker 3: What do you think, well best hard past.
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  Speaker 2: What I've just described is the active side of indexing.
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  Speaker 2: I've got a monograph coming out shortly cfa Institute Research
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  Speaker 2: Foundation monograph called the Active Side of Indexing, and indexing
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  Speaker 2: is described as passive. But if it has turnover, the
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  Speaker 2: ninety five percent is passive. It moves up and down
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  Speaker 2: with the market movements, and it's blissfully ignorant and indifferent
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  Speaker 2: to what's going on in the economy or the companies
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  Speaker 2: or whatever. It is really passive. The five percent looks
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  Speaker 2: like a hyper growth manager on crystal math. So, and
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  Speaker 2: the waiting is also an issue. Why if I came
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  Speaker 2: to you and said I've got a brilliant I'm gonna wait.
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  Speaker 2: Stocks proportional to their price. So the more expensive they are,
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  Speaker 2: the bigger it's weighting your portfolio. Don't you just love it?
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  Speaker 3: So let's dive into that a little bit. I know
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  Speaker 3: anybody who's in an index or watches in horror every
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  Speaker 3: time something gets added to the index, and then there's
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  Speaker 3: this grace period where the stock runs up and it's
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  Speaker 3: even more expensive when it gets added. It's even worse
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  Speaker 3: when there's a deletion. They announce a deletion and they plummet,
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  Speaker 3: anticipating front running the sell.
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  Speaker 2: Is this just a hidden goront running?
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  Speaker 3: I mean, if you're going to tell me you're going
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  Speaker 3: to sell, Hey, we have two trillion dollars in this index.
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  Speaker 3: We're going to sell this position in a month, why
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  Speaker 3: would you hold onto that exactly?
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  Speaker 2: S and P is a beautiful example. S and P
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  Speaker 2: is now big enough that the stocks held in S
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  Speaker 2: and P index funds represent roughly twenty five percent of
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  Speaker 2: the total market cap of every stock that's in the index,
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  Speaker 2: not each individual ETF or index fund, but aggregated. And
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  Speaker 2: that means that to the extent that indexers are obsessed
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  Speaker 2: with having no tracking error with matching the index. They're
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  Speaker 2: going to buy that stock at the same price that
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  Speaker 2: it's added to the index, which means a market on
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  Speaker 2: close price. I will pay whatever the price is at
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  Speaker 2: the close on the day that it's added to the index. Now,
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  Speaker 2: if you're a hedge fund, you're going to want to
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  Speaker 2: accommodate that and help out by buying it early and
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  Speaker 2: then flipping it to the indexers. And so that's been
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  Speaker 2: going on for core a century or more. I documented
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  Speaker 2: the pattern back in nineteen eighty six in a article
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  Speaker 2: called S and B Additions and Deletions of Market Anomaly,
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  Speaker 2: and I heard anecdotally that that was used. That article
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  Speaker 2: was used in part to lobby S and P to
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  Speaker 2: pre announce so that index funds wouldn't get nailed by
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  Speaker 2: the index changes. Now they're going to buy this and
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  Speaker 2: sell that, and they're buying it higher and selling this lower,
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  Speaker 2: and so they have an automatic drag. The magnitude of
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  Speaker 2: that drag is actually very simple. If you could transact
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  Speaker 2: at the price at which S and P announced the decision,
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  Speaker 2: not the price at which it becomes effective, you would
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  Speaker 2: add fifteen basis points per annum. So the indexes lose
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  Speaker 2: fifteen basis points just from trading costs. With five percent
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  Speaker 2: annual turnover or less three to five percent annual turnover,
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  Speaker 2: that's equivalent to three to five hundred basis points per
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  Speaker 2: stock per trade. That's a heavy trading cost. But it's
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  Speaker 2: because it's crowded space. It's a herd of elephants trying
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  Speaker 2: to go through a single revolving door.
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  Speaker 3: Let's talk about the flip flop problem. Every time there's
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  Speaker 3: an addition, something like twenty eight percent within a decade
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  Speaker 3: get dropped. And similarly, after there's a deletion, almost half
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  Speaker 3: of those deletions rejoin the S and P within a decade.
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  Speaker 3: What is this flip flop due to performance?
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  Speaker 2: Well, it does what you would expect. When I did
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  Speaker 2: my little thought experiment describing a brilliant strategy, I was
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  Speaker 2: actually citing statistics from our flip Flops paper. On average,
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  Speaker 2: stocks that are added are added after seventy five percentage
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  Speaker 2: points of outperformance. If they falter and are kicked back out,
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  Speaker 2: they're removed at a seven thousand basis point loss. Now,
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  Speaker 2: if you gain seventy five and lose seventy, you aren't
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  Speaker 2: back where you started. You're down fifty, and it's worse
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  Speaker 2: than that because you didn't participate in the seventy five.
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  Speaker 2: You did participate in the down seventy. The deletion flip
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  Speaker 2: flop stocks that are deleted and re added are even
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  Speaker 2: more dramatic. They underperformed by thirty five hundred basis points,
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  Speaker 2: give or take in the year before they're dropped, and
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  Speaker 2: then they outperformed by one hundred and eighty percentage points.
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  Speaker 2: They roughly triple relative to the market before they're added
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  Speaker 2: back in. So flip flops are very, very costly. And
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  Speaker 2: none of this is disrespect to the index providers. Is
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  Speaker 2: this stuff has not been studied much until we took
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  Speaker 2: a deep dive into it. If you don't know you
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  Speaker 2: have a problem, how are you going to fix it?
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  Speaker 2: And the problem is big, but it's on a very
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  Speaker 2: small part of the portfolio. It's on the active side
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  Speaker 2: of indexing, the little sliver of active trading.
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  Speaker 3: Huh, really interesting, So let's talk about fixing it. You
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  Speaker 3: have been discussing for as long as I know you,
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  Speaker 3: which is decades, economy waiting in disease rather than cap
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  Speaker 3: weighting or price waiting to find what a fundamental economic
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  Speaker 3: waiting of an index is what goes into that.
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  Speaker 2: Let's suppose you want an index that studiously mirrors the
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  Speaker 2: economy instead of studiously mirroring the market. Well, you wouldn't
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  Speaker 2: wait companies by market cap. You wouldn't choose them based
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  Speaker 2: on market cap. Let's choose them based on how big
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  Speaker 2: their business is. Well, how do you define that? How
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  Speaker 2: bigger its sales, how bigger it's profits, How big is
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  Speaker 2: it's net worth? Today we would go a step further
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  Speaker 2: and say net worth adjusted for intangibles, how much does
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  Speaker 2: it distribute to shareholders and dividends and buybacks? Four different measures.
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  Speaker 2: You could argue endlessly about which is right, or you
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  Speaker 2: could simply say, I'm going to take the average of
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  Speaker 2: the four weights. So Nvidia is a decent slug of
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  Speaker 2: total profits in the economy, but it's not seven or
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  Speaker 2: eight percent, not its market weight. It's in the two
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  Speaker 2: percent range in terms of sales, it's in the two
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  Speaker 2: percent range in terms of dividends or net worth. It's
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  Speaker 2: rounds to a very very small number. So you could argue,
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  Speaker 2: is that half a percent or one percent or two
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  Speaker 2: percent it's average those You're going to say it's about
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  Speaker 2: one one and a half percent of the economy. Okay,
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  Speaker 2: that's big enough to make the cut. We're going to
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  Speaker 2: include it, and we'll include it at one one and
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  Speaker 2: a half percent weight. Now, if you do that, what
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  Speaker 2: you're doing is taking the frothy gross stocks, beloved and
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  Speaker 2: expected to grow fabulously and downweighthing them to their current
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  Speaker 2: economic footprint. You're taking the value stocks, the unloved outa
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  Speaker 2: favor cheap stocks, and you're saying, let's reweight those up
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  Speaker 2: to their economic footprint. So you wind up with a
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  Speaker 2: stark value tilt. And that means the sensible way to
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  Speaker 2: measure RAFFI the fundamental index is to measure it against
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  Speaker 2: the value indexes. And that's where it gets really interesting.
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  Speaker 2: Schwab and Invesco have ETF some mutual funds, Pimco has
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  Speaker 2: some ETFs tied to the fundamental index, and collectively those
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  Speaker 2: three organizations have over one hundred billion dollars in RAFFIE assets.
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  Speaker 2: So this is not it's not new, it's not small.
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  Speaker 2: We introduced the idea about twenty years ago. If you
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  Speaker 2: compare it with the cap weighted value indexes, you get
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  Speaker 2: an astonishing result. The on average RAFFI beats the cap
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  Speaker 2: weighted value indexes by two to two and a half
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  Speaker 2: percent per year compounded, and does so with variability.
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  Speaker 3: How does that How does that compare to the cap
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  Speaker 3: weighted growth indexes.
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  Speaker 2: The growth indexes have outperformed hugely, but they've outperformed by
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  Speaker 2: dint of becoming more and more expensive relative to fundamentals.
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  Speaker 2: The underlying fundamentals, the value of the value indexes in
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  Speaker 2: terms of sales, profits, book value dividends has have grown
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  Speaker 2: roughly parapassu with growth portfolios this century today, which shocks
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  Speaker 2: most people because the relative performance has been about two
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  Speaker 2: to three percent per annum for a quarter century, and
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  Speaker 2: the notion that wow, this has beat this now by
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  Speaker 2: call it something on the order of two to one
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  Speaker 2: ten thousand basis points out performance, but the underlying fundamentals
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  Speaker 2: have grown in parallel.
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  Speaker 3: Let me re ask that question in a different way,
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  Speaker 3: which is, if we know there's a disadvantage to cap
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  Speaker 3: weighted indexes, well, isn't the obvious and simple alternative just
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  Speaker 3: equal weight? Why not just go equal weight?
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  Speaker 2: Equal Weighting is a perfectly legitimate way to create a portfolio.
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  Speaker 2: It's going to have a stark small cap tilt because
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  Speaker 2: a tiny company will get the same weight as in
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  Speaker 2: video as exon mobile. It will have a stark value
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  Speaker 2: bias because companies that are trading at low multiples will
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  Speaker 2: get the same way to stocks trading at high multiples.
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  Speaker 2: It will have a rebalancing alpha. If it stock soars,
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  Speaker 2: you're going to trim it. If it tumbles, you're going
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  Speaker 2: to top it up. The only achilles heel that I
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  Speaker 2: think matters for equal weighting is equal weighting what stocks.
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  Speaker 2: Equal weighting the S and P. For instance, you're going
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  Speaker 2: to be equal weighting a portfolio that includes companies that
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  Speaker 2: have soared onto into being big enough to be added.
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  Speaker 2: You're going to be leaving out companies that have performed
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  Speaker 2: badly enough to be really cheap. And the result is
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  Speaker 2: that you're going to have a portfolio that's biased towards
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  Speaker 2: higher multiple stocks. So interestingly, equal weighting over long periods
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  Speaker 2: of time performs about the same as fundamental index, which
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  Speaker 2: we launched twenty years ago, and that but with much
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  Speaker 2: more variability.
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  Speaker 3: Got it that that makes a lot of sense. So
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  Speaker 3: if you're if we're looking at a fundamental driven index
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  Speaker 3: in a period where you know megacaps are dominating or
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  Speaker 3: growth are dominating. How do you ride that out? Up
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  Speaker 3: until last year, it felt like if you weren't overweight
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  Speaker 3: the MAG seven, you were underperforming. Until we learned last
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  Speaker 3: year five of the seven MAG seven underperformed in twenty
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  Speaker 3: twenty five.
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  Speaker 2: Yeah, yeah, shocking. The thing that I find interesting here
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  Speaker 2: is we introduced Fundamental Index in two thousand and five,
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  Speaker 2: and live strategies at Pimco go back to mid two
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  Speaker 2: thousand and five. At Investo go back to late two
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  Speaker 2: thousand and five, So it's live, it's been investable for
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  Speaker 2: twenty years. The thing that's interesting is just two years later,
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  Speaker 2: two thousand and seven, Value crested and it underperformed ferociously
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  Speaker 2: until summer of twenty twenty. Since then, it's been bottom bouncing,
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  Speaker 2: outperforming handily, then crashing, outperforming, then crashing, bottom balancing, and
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  Speaker 2: so at the end of twenty twenty five, Value had
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  Speaker 2: underperformed Russell. Value had underperformed the Russell one thousand peaked
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  Speaker 2: to trough by thirty eight hundred basis points. You were
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  Speaker 2: thirty eight percent poorer than a simplest Russell or SMP
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  Speaker 2: index investor. That's a horrific headwind for anything with a
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  Speaker 2: value tilt RAFI fundamental index has a rebalancing elpha stock
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  Speaker 2: soares and it's fundamentals don't validate that, then you're going
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  Speaker 2: to say, thanks for the nice high price, I'm going
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  Speaker 2: to trim it. If it tanks and the fundamentals don't falter,
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  Speaker 2: you're going to say, thanks for the bargain, I'm going
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  Speaker 2: to top it up.
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  Speaker 3: So let's talk a little more about that rebalancing strategy.
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  Speaker 3: What sort of alpha does that create? How does that
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  Speaker 3: drive returns.
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  Speaker 2: The best way to measure the performance of RAFFIA is
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  Speaker 2: against the cap weighted value indexes relative to the value indexes.
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  Speaker 2: This is live. The RAFFI indexes have beat the cap
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  Speaker 2: weighted value indexes by a little over two percent per
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  Speaker 2: year compounded. Now with compounding, that's a big number. That
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  Speaker 2: means that you're over fifty percent richer than you were
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  Speaker 2: with a cap weighted value index after twenty years, So
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  Speaker 2: that's important. Now, the other thing that's interesting is relative
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  Speaker 2: to the value indexes. The tracking error is pretty it's
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  Speaker 2: about two and a half percent variability in that two
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  Speaker 2: percent value ad, which means that RAFFI has beat cap
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  Speaker 2: weighted value in most years when value has been winning
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  Speaker 2: and in most years when value has been losing, it
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  Speaker 2: doesn't matter. RAFFI has been winning at about three out
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  Speaker 2: of every four years, and this is live. This is
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  Speaker 2: not a back test.
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  Speaker 3: So to wrap up, investors who are concerned about market concentration,
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  Speaker 3: concerned about valuation, but a little skittish on the underperformance
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  Speaker 3: that value has created in a cap weighted format should
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  Speaker 3: consider a fundamental index. It trades differently than both growth
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  Speaker 3: and value and has a better risk profile and a
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  Speaker 3: better evaluation profile. I'm Barry redults, you're listening to Bloombergs
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  Speaker 3: at the money