Our 300th Episode Mailbag Special – Plus, the 'Godfather of Fundamental Indexing' Rob Arnott

Episode #300 | March 6, 2023

Episode #300 | March 6, 2023

Our 300th Episode Mailbag Special – Plus, the 'Godfather of Fundamental Indexing' Rob Arnott

In This Episode

This week, you'll get a glimpse of what goes on in the mind of a true innovator in financial strategy. Hailed by Dan as the "godfather of fundamental indexing," Rob Arnott, founder and chairman of the board of Research Affiliates, returns for another provocative interview.

As promised, Dan and his co-host Corey kick things off with a mailbag special to celebrate Stansberry Investor Hour's 300th episode. Thanks to listeners like you, we've collected quite a few e-mails. So today, the duo will tackle a couple of the burning questions you've sent us.

Another milestone in today's episode comes in the form of Research Affiliates' proprietary RAFI Fundamental Index ("RAFI") strategy, which is nearing its 20th anniversary. Rob shares some history about his pioneering work that's used by industry heavyweights like Charles Schwab and PIMCO.

Since the 1990s, Rob has been toying with the idea of looking past the traditional investing strategy of weighting stocks by market capitalization. So in 2004, he and his team created RAFI, a strategy that weights a stock based on the underlying fundamentals of a business...

That's when it hit us. Why would [RAFI] consistently add value? Because it breaks the link between the weight in the portfolio and the price of the stock. If the price doubles and the underlying fundamentals don't, the fundamental index will say, "Oh, trim it." If a stock tanks and the fundamentals don't, the fundamental index will say, "Thanks for the deep discount – I'm topping it back up," which means you get a rebalancing alpha [...]

So when you contratrade against the market, you're capturing a rebalancing alpha. But you're also creating a value tilt because the growth stocks are reweighted down to their economic footprint and the value stocks are reweighted up to their economic footprint. And the result is you have this stark value tilt.

He back-tested the strategy with 500 of the largest stocks weighted by sales using 30 years of data. The result? "A lot of active managers would sell their grandmother to get to 2.5%," Rob quips, referring to how much RAFI outperformed the S&P 500 Index.

Rob also warns against following the herd by explaining what happens when you mix availability bias and a bubble. And, with the help of monkeys, he shares how inherently flawed the traditional idea of weighting only by market cap can be... In a nod to economist Burton Malkiel – who once wrote how a blindfolded monkey throwing darts could outperform a fund manager – Rob and his colleagues simulated the monkey for one of their research papers...

On average, the monkey portfolio beat the S&P by 160 basis points a year. That's just from breaking the link with price. Fundamental Index breaks the link with price but still keeps the link with the underlying fundamentals, meaning you're not loading up on tiny companies that are hard to trade – you're loading up on big businesses which are usually large-cap stocks.

You're going to underweight the Teslas of the world and overweight the Chevrons of the world... because Chevron is out of favor, unloved, and relatively cheap, and Tesla is beloved, frothy, and expensive. But you'll still own both of them, and you'll be earning money from the market's constantly changing opinion of what Tesla is worth or what Chevron is worth. And because it's weighted in accordance with the size of the business – and the size of the business doesn't change very much from year to year – the [portfolio] turnover is shockingly low.