Saturday, June 4, 2011

"Robert Arnott's Magic Indexing Formula"

We have been fans of Mr. Arnott since his days as editor of the Financial Analysts Journal.
The into to this piece cracked me up, we'll link to the Bloomberg article below.
From Forbes:
Robert Arnott, resplendent in a purple-check jacket, purple-striped shirt, and purple-print tie, is regaling his staff with tales of his favorite hobby: chasing solar eclipses from the ice floes of Antarctica to the singing sand mountains of the Gobi Desert. The scene is the ritual daily luncheon inside the cavernous conference room at Research Affiliates, Arnott's fast-growing eight-year-old investment research firm in Newport Beach, Calif. On this sunny Thursday in April, Ph.D.s from as far away as China and Russia sample Turkish cuisine, share ideas for applying game theory to portfolio design, and swap ferocious forehands at the Ping-Pong table. It all has the loose, zany vibe of the cafeteria at a university research lab.

Arnott is well-suited to the role of mad professor. The burly, goateed 55-year-old plows through life with a nonstop enthusiasm that he channels into an assortment of extreme hobbies. He is an avid collector of both the world's fastest vintage motorcycles -- he recently paid $100,000 for a Morbidelli from Italy with a miniature Ferrari engine -- and the graffiti art of Banksy, the phantom underground British painter famed for masking his identity. But Arnott loves nothing more than retelling his eclipse-seeking adventures.

In his rich bass voice, Arnott recounts an epic expedition to Paraguay in the mid-1990s. "We drove nine hours on dusty, bumpy roads to a tiny cow town called Filadelfia," he says. "We hopped the fence of a ranch to see the eclipse, and the owners rushed over to kick us off. When we explained that this happens once every 360 years and only lasts five minutes, they stayed and were mesmerized. A woman cried tears of joy when she saw the moon blot out the sun. I've seen that reaction many times at eclipses."

When he's not circling the globe in search of celestial rapture, Arnott is easily one of the most important figures working in the investment world today. At Research Affiliates he has created a menu of exchange-traded funds, mutual funds, and other offerings that now manage a total of $52 billion (most through indexes licensed to big institutions). But his influence extends well beyond the size of those portfolios.

Arnott's innovative approach to designing and marketing index products has rocked the investment world. "No one is having a bigger impact in reevaluating the full and hidden costs of conventional indexing," says Brent R. Harris, a managing director at nearby Pimco, the $1 trillion money management colossus for whom Arnott directs a family of funds. "He's also creating a better alternative with a proven track record."...MORE
And Bloomberg's take, sans the fashion info:

Arnott Index Derided by Bogle as Witchcraft Beats Vanguard Fund
As Robert Arnott was deciding whether to start his own investment firm, he met with his hero John Bogle for dinner. At a steakhouse in downtown Philadelphia in 2001, the founder of indexing powerhouse Vanguard Group Inc. spoke with enthusiasm about running his own firm. Bogle, who’s now 82, told Arnott that starting a company could be rewarding once your investing ideas catch fire.

Arnott, 56, says Bogle inspired him to set up Research Affiliates LLC less than a year after that dinner. Arnott then went on to shake the foundation on which the older man built Vanguard: indexing that allocates equities based on market capitalization, Bloomberg Markets magazine reports in its July issue.
Arnott debuted in 2005 a new type of indexing that uses fundamental measures such as cash flow to pick stocks -- a methodology that the father of indexing would later denounce as “witchcraft” in an interview with Morningstar Inc. (MORN) because of its similarity to active management and higher costs. By 2011, the innovator’s brand of stock indexing had produced better returns than Bogle’s.

The PowerShares FTSE RAFI US 1000 Portfolio (PRF) ETF, which is based on Arnott’s methodology, advanced at an average annual rate of 5.3 percent from its inception on Dec. 19, 2005, through May 9. That beats the flagship Vanguard 500 Index Fund’s 3.2 percent return, according to data compiled by Bloomberg. Armed with those results, Arnott is now planning to stir up the world of bond funds.

Bond Indexes
As the U.S. and Europe struggle with record deficits, the money manager is building a new set of bond indexes that shun the world’s most indebted nations and favor developing economies with smaller obligations.
“Fundamental indexing in bonds may very well be bigger than in stocks,” Arnott says. “We’re looking now at how a debt burden affects gross domestic product and capital markets, and it paints a pretty scary picture.”
Economists and money managers, including Clifford Asness, founder of AQR Capital Management LLC, the $38.8 billion hedge fund, have derided Arnott’s indexes. “Rob’s a good guy; he’s very smart,” says Bogle, who retired as Vanguard’s chairman and chief executive officer in 1996. “He has beaten the market over the past five years, but one might want to think about what goes into that: risk.”

Eugene Fama, a professor of finance at the University of Chicago’s Booth School of Business who helped develop the efficient market hypothesis, said Arnott’s indexes represent a triumph of marketing rather than an innovation in investing. ...MORE
Lastly, from Future of Capitali$m:
Robert Arnott's Deriders
...What the article doesn't mention is that Professor Fama is a "board member of Dimensional Fund Advisors" and a consultant for Dimensional's Fixed Income and Value Strategies. In other words, he's a money manager that competes with Mr. Arnott.
Likewise, the Bloomberg article reports:
As investors started buying fundamental index funds, traditionalists publicly attacked them. Bogle, now president of Vanguard's Bogle Financial Markets Research Center, and Burton Malkiel, a Princeton University economics professor, penned a column in the Wall Street Journal in June 2006 criticizing fundamental index funds for charging higher management fees and expenses that were five to 10 times as much as those levied by traditional index funds.
Like Professor Fama, Professor Malkiel is identified by Bloomberg only with his academic affiliation. There's no mention that Professor Malkiel is the chief investment officer of Alphashares, another firm that competes with Mr. Arnott.
While Malkiel doesn't interest me, we've had a few posts on Mr. Asness:
How Asness's firm lost $17 billion in two years—and made it up in one.
And in "General Electric Dividend: Good Sign or Management out of Ideas? (GE)":
It is usually a good thing when companies dividend out cash to the owners rather than investing it in some self-aggrandizing managerial wish list. Robert Arnott and Clifford Asness did a nifty little 18-page paper that looks at the issue:
Surprise! Higher Dividends= Higher Earnings Growth
We have so many posts on Arnott that it is probably easiest to do a Google search of the blog: robert arnott