Reexamining The Market Portfolio: Have Our Equilibrium Models Been Misspecified?

Reexamining the Market Portfolio:
Have our Equilibrium Models been Misspecified?
Chicago Quantitative Alliance

September 22, 2004
Robert D. Arnott
The Essence of Asset Management
 “The essence of investment management is the

management of risks, not the management of
returns.”
- Benjamin Graham
 “Investing is a “loser’s game,” in which the

winner is often the investor who makes the
fewest errors.”
- Charley Ellis
2
What Returns Can We
Reasonably Expect?
The Arithmetic of Returns
 Stocks: 3.0% real IRR; 0% real 5-year return

 Bonds: 2.5% real IRR; 3% real 5-year return
 TIPS: 2.3% real IRR; 3.5% real 5-year return
4
What is the Current Risk Premium?
Real Stock Returns (erring on the high side?)
1.8% 2.7% 1.5% 3.0%

Dividend Yield + Long-Term Real – Growth from New = Long-Term Real
GDP Growth Enterprise Creation Return from Stocks
Real Bond Returns
2.3% 0.7%
– Current Yield = Long-Term Risk
Long TIPS Premium from Stocks
Current Risk Premium is Very Weak …
for stocks relative to inflation-indexed government-

guaranteed bonds!
5
Concrete Implications of Lower Returns
The simple fact is that

neither stocks nor bonds
is priced to offer real returns
above about 3%,
and may deliver considerably less.
6
Three Paths to Improved Returns
 Consider Other Asset Classes

• Stocks and Bonds are not the only choices
• Unconventional assets can be priced to offer better returns.
 Seek Alpha – or Eliminate Negative Alpha
• Conservatively, focusing on avoiding negative alpha, or
• Aggressively, if you have confidence in the opportunities
 Actively Manage the Asset Mix
• Include alternative markets in these decisions
• Seek assets which are out of favor, priced for better returns
 All Three Paths Can Be Pursued in Parallel!
 Fourth Path, Leverage, Increases Risk and Exposure to

Kurtosis
7
Which Risk Do You Want To Control?
8
Our Biggest Bets are in Equities –
Can We Improve our Indexes?!
The Super-EMH Paradox
 Suppose we have something better than strong-form EMH

 Perfect foresight; MV = TFV; index is perfectly mean variance efficient.
 Suppose our crystal ball gets just *a little* cloudy.
 MVW index suffers a return drag.
 Suppose we structure an index which is valuation-indifferent
 Return drag disappears. Equal Weighting does this.
 Can we quantify the return drag? Yes. It’s 2-4%.
 How do we reconcile ostensibly efficient market-clearing cap-
weighted portfolio with a return drag that’s easy to eliminate?
10
11
Are We Blinded by Theory?
Blinded by Theory?
 Theory does a Marvelous Job explaining how the

world ought to work
 Theories are sometimes provable, based on
certain assumptions
 Gaps between theory and reality are normal
 Still, some observers cling to theory as fact
13
What’s Right about Cap-Weighting?
 Passive, requiring little trading

• Commands low fees
• Incurs light trading costs
 Participates in broad market, owns most of the
market economy
• Can be used on an immense scale
 Seen as theoretically robust, very near to mean-
variance optimality
• Seen as being on the efficient frontier
14
Can We Improve on Cap-Weighting?
Can we Improve on Cap-Weighting?
 How do we construct an index that strips away

the return drag of Cap-Weighting?
• Replicable, objective, valuation-indifferent & large, liquid bias
 Why not index to a measure of size other than
Market Cap – Call it Fundamental Indexing?!
• Could do book value indexing,
• Revenues-based indexing,
• Sales-based indexing,
• Earnings-based indexing,
• Dividend indexing,
• even Headcount-based indexing.
 Can Fundamental Indexing work? Absolutely.
16
How Important is Asset Selection
vs Asset Weighting?
Return 1000 Firms 1974 - 2002
Wei ght:
Sort: Cap BK Inc 5y Inc DY PO EY Eq
Cap 11.6% 13.2% 13.6% 13.5% 11.8% 13.6% 15.4% 13.6%
BK 11.7% 13.3% 13.8% 13.6% 12.1% 14.0% 16.2% 14.3%
Inc 11.8% 13.7% 13.8% 13.7% 12.6% 14.5% 16.8% 15.2%
5yr Inc 11.8% 13.5% 13.8% 13.6% 12.2% 14.0% 16.3% 14.6%
DY 10.9% 12.5% 12.5% 12.5% 12.2% 12.9% 15.7% 13.4%
PO 11.8% 13.4% 13.4% 13.3% 12.7% 13.7% 17.0% 14.9%
EY 16.4% 17.8% 17.7% 17.7% 17.5% 20.6% 23.8% 22.5%
• Note that Style Indexes Screen by Style – then Weight by Capitalization.

Doesn’t this throw away some of the potential benefit of the screening?
© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

Duplication or dissemination prohibited without prior written permission. 17
How Well Do
Fundamental Indexes Work?
Excess Excess
Ending Geometric Sharpe Return vs Return
Value of $1 Return Volatility Ratio REF CAP t-stat
S&P 500 $ 66.79 10.52% 15.3% 0.304 0.09% 0.33
REFERENCE CAP $ 64.42 10.43% 15.5% 0.294 - -
BOOK $ 104.80 11.71% 15.2% 0.384 1.28% 2.19
INCOME $ 131.41 12.31% 15.2% 0.422 1.88% 3.34
REVENUE $ 140.24 12.49% 15.8% 0.418 2.06% 2.97
SALES $ 137.97 12.45% 15.7% 0.417 2.02% 2.91
GROSS DIV $ 101.86 11.63% 13.9% 0.413 1.20% 1.63
# EMPLOYEES $ 134.79 12.39% 16.0% 0.407 1.96% 2.69
COMPOSITE $ 135.18 12.39% 15.3% 0.426 1.96% 2.86
Average (x-COMP) $ 125.18 12.17% 15.3% 0.410 1.74% 2.62
Equal Wt REF CAP $ 122.83 12.15% 17.3% 0.362 1.72% 2.07
18
How Strong is the CAPM Alpha?
How High is the Relative Risk?
Excess Excess CAPM Tracking

Geometric Return vs Return Beta vs Correlation Error vs
Return REF CAP t-stat REF CAP vs REF CAP REF CAP
S&P 500 10.52% 0.09% 0.33 1.00 99% 1.79%
REFERENCE CAP 10.43% - - - - -
BOOK 11.71% 1.28% 2.19 0.95 97% 3.80%
INCOME 12.31% 1.88% 3.34 0.95 97% 3.66%
REVENUE 12.49% 2.06% 2.97 0.98 96% 4.50%
SALES 12.45% 2.02% 2.91 0.98 96% 4.50%
GROSS DIV 11.63% 1.20% 1.63 0.85 95% 4.79%
# EMPLOYEES 12.39% 1.96% 2.69 0.99 96% 4.73%
COMPOSITE 12.39% 1.96% 2.86 0.99 96% 4.45%
Average (x-COMP) 12.17% 1.74% 2.62 0.95 96% 4.33%
Equal Wt REF CAP 12.15% 1.72% 2.07 1.06 95% 5.39%
19
How Significant is the CAPM Alpha?
Excess Excess CAPM

Geometric Return vs Return Alpha vs standard t-stat for
Return REF CAP t-stat REF CAP error Alpha=0
S&P 500 10.52% 0.09% 0.33 0.09% 0.26% 0.35
REFERENCE CAP 10.43% - - - - -
BOOK 11.71% 1.28% 2.19 1.50% 0.58% 2.56
INCOME 12.31% 1.88% 3.34 2.09% 0.56% 3.71
REVENUE 12.49% 2.06% 2.97 2.16% 0.70% 3.09
SALES 12.45% 2.02% 2.91 2.18% 0.70% 3.12
GROSS DIV 11.63% 1.20% 1.63 1.88% 0.67% 2.79
# EMPLOYEES 12.39% 1.96% 2.69 2.02% 0.69% 2.93
COMPOSITE 12.39% 1.96% 2.86 2.21% 0.58% 3.81
Average (x-COMP) 12.17% 1.74% 2.62 1.97% 0.65% 3.03
Equal Wt REF CAP 12.15% 1.72% 2.07 1.38% 0.71% 1.95
20
How Liquid are the
Fundamental Indexes?
Excess Weighted $ Weighted

Geometric Return vs Concentrat Trading Trading
Return REF CAP CAP Ratio ion Ratio Volume* Days*
REFERENCE CAP 10.43% - 1.00 55.06% 191 MM 0.9
BOOK 11.71% 1.28% 0.64 51.46% 134 MM 1.5
INCOME 12.31% 1.88% 0.65 57.06% 126 MM 1.3
REVENUE 12.49% 2.06% 0.55 54.66% 105 MM 2.0
SALES 12.45% 2.02% 0.54 52.48% 99 MM 1.7
GROSS DIV 11.63% 1.20% 0.71 61.99% 110 MM 1.6
# EMPLOYEES 12.39% 1.96% 0.38 42.76% 70 MM 9.3
COMPOSITE 12.39% 1.96% 0.66 51.76% 102 MM 1.5
Average (x-COMP) 12.17% 1.74% 0.58 53.40% 107 MM 2.9
Equal Wt REF CAP 12.15% 1.72% 0.14 10.00% 39 MM 2.5
21
How Much Will Trading Costs
Hurt Our Returns?
Excess Excess Ret. Each Way

Geometric Return vs @ 1% Cost for 0%
Return REF CAP Turnover Trade Cost Excess Ret.
REFERENCE CAP 10.43% - 6.30% - -
BOOK 11.71% 1.28% 13.20% 1.15% 9.30%
INCOME 12.31% 1.88% 12.14% 1.77% 16.12%
REVENUE 12.49% 2.06% 14.15% 1.91% 13.15%
SALES 12.45% 2.02% 13.41% 1.88% 14.19%
GROSS DIV 11.63% 1.20% 11.10% 1.11% 12.53%
# EMPLOYEES 12.39% 1.96% 14.56% 1.79% 11.86%
COMPOSITE 12.39% 1.96% 10.55% 1.88% 23.11%
Average (x-COMP) 12.17% 1.74% 13.09% 1.60% 12.86%
Equal Wt REF CAP 12.15% 1.72% 20.66% 1.68% 6.84%
22
Are We Just Proxying for
Fama-French or APT Factors?
 Do Fundamental Indexes capture something

beyond APT or FF-3?
• Not exactly. FF-3 alpha is zero.
• But, perhaps FF-3 factors are mainly capturing the structural
return drag of indexation?

Hence the positive return for smaller size or distress
• How would the S&P alpha look if FF-3 were recast based on
Fundamental indexes?!
23
Does it Deliver a Fama-French Alpha?
Value Size
Excess CAPM (distress) (liquidity)
Return Alpha FF-3 Alpha Equity Beta Beta Beta
BOOK 1.28% 1.50% -0.10% 1.03 0.27 (0.07)
t-Stat (0.23) 119.04 20.16 (6.52)
INCOME 1.88% 2.09% 0.28% 1.04 0.29 (0.09)
t-Stat 0.72 133.30 24.66 (8.60)
REVENUE 2.06% 2.16% -0.19% 1.07 0.35 0.01
t-Stat (0.40) 112.43 24.28 0.96
SALES 2.02% 2.18% -0.20% 1.06 0.34 0.03
t-Stat (0.42) 111.88 23.86 2.10
GROSS DIV 1.20% 1.88% -0.27% 0.96 0.35 (0.14)
t-Stat (0.56) 99.79 23.87 (10.96)
CFUND 1.96% 2.21% -0.06% 1.03 0.31 (0.07)
t-Stat (0.15) 127.60 24.79 (6.73)
24
Semantics and Fundamental Indexing
 Is a “Fundamental Index” an index? Sure.

• Anything can be an index.
 Is “Fundamental Indexing” passive? As much as
R2000V or Wilshire Growth.
• It's replicable, formulaic and objectively constructed.
 Is it a “market portfolio”? Not in CAPM context.
• “Main Street Indexing" versus “Wall Street Indexing."
• Then again, nothing qualifies as true market portfolio
 Did we construct it to beat the cap-weighted
indexes? Yes.
• Does that make it active? Not unless we want to call R2V
"active," since most investors in R2V are using it for “alpha. ”
25
Return Comparisons,
1962 - 2003
Comparison of Indexes, 1962-2003
Growth of $1.00 from 1/1/62 through 12/31/03

140
130
120
110
100
90
Unit Value
80
70
60
50
40
30
20
10
0
1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
S&P 500 Book 1000 Revenue 1000 Cap 1000

Value Added, Book Value Index
vs Cap Index, 1962-2003
Growth of $1.00 from 1/1/62 to 12/31/03

120.0
100.0
80.0
Unit Values
60.0
40.0
20.0
0.0
1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
Book 1000 Cap 1000 Value Added by Book 1000 over Cap 1000
Value Added, Revenue Index
vs Cap Index, 1962-2003
Growth of $1.00 from 1/1/62 to 12/31/03

1 40
1 20
1 00
Unit Values
80
60
40
20
0
1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
Revenue 1000 Cap 1000 Value Added by Revenue 1000 over Cap 1000
Are We Just Capturing Risk Premium
for More Extreme Outliers?
Outlier Test for Index Robustness
max
excess max monthly min monthly calendar min calendar
skewness kurtosis ret ret year ret year ret
S&P500 (0.32) 1.72 17.0% -21.7% 38.1% -26.7%
REFERENCE CAP (0.33) 1.60 18.3% -21.2% 36.7% -28.6%
BOOK (0.29) 1.83 18.2% -21.1% 44.3% -24.1%
INCOME (0.24) 1.77 18.1% -20.5% 43.7% -23.6%
REVENUE (0.33) 2.14 19.8% -23.0% 48.2% -21.7%
SALES (0.33) 2.17 19.8% -23.0% 48.2% -21.6%
GROSS DIV (0.17) 1.77 17.7% -18.4% 43.0% -23.1%
# EMPLOYEES (0.36) 2.38 21.3% -23.5% 48.1% -24.3%
COMPOSITE (0.34) 2.14 19.3% -22.3% 48.0% -22.7%
Average (x-COMP) (0.28) 2.01 19.2% -21.6% 45.9% -23.1%

Outlier Test for Index Robustness
max
max min max trail min trail calendar min calendar
quarterly ret quarterly ret 12mo ret 12mo ret year ret year ret
S&P500 22.8% -25.3% 61.4% -39.0% 38.1% -26.7%
REFERENCE CAP 23.7% -26.1% 64.1% -41.8% 36.7% -28.6%
BOOK 26.1% -22.5% 64.2% -35.5% 44.3% -24.1%
INCOME 26.4% -22.5% 66.7% -36.3% 43.7% -23.6%
REVENUE 30.0% -24.4% 70.2% -34.3% 48.2% -21.7%
SALES 30.0% -24.3% 70.0% -34.2% 48.2% -21.6%
GROSS DIV 24.6% -20.6% 60.3% -35.1% 43.0% -23.1%
# EMPLOYEES 31.5% -23.6% 69.5% -36.9% 48.1% -24.3%
COMPOSITE 28.7% -23.7% 66.9% -34.5% 48.0% -22.7%
Average (x-COMP) 28.1% -23.0% 66.8% -35.4% 45.9% -23.1%

Results Decade-by-Decade
1962-1969
Growth of $1.00 from 1/1/62 to 12/31/69

2.75
2.50
2.25
2.00
Index Values
1.75
1.50
1.25
1.00
0.75
1961 1962 1963 1964 1965 1966 1967 1968 1969

1970-1979
Growth of $1.00 from 1/1/70 to 12/31/79
2.5
2.0
Index Values
1.5
1.0
0.5
1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979

1980-1989
Growth of $1.00 from 1/1/80 to 12/31/89
5.5
5.0
4.5
4.0
Index Values
3.5
3.0
2.5
2.0
1.5
1.0
0.5
1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

1990-1999
Growth of $1.00 from 1/1/90 to 12/31/99
6.0
5.5
5.0
4.5
4.0
Index Values
3.5
3.0
2.5
2.0
1.5
1.0
0.5
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

2000-2003
Growth of $1 1/1/2000 to 12/31/2003
1.00
0.75
0.50
1999 2000 2001 2002 2003

Stress-Testing Fundamental Indexing in
Diverse Market & Economic Environments
Returns, by Decade
Performance by Decade 1962-69 1970-79 1980-89 1990-99 2000-03

S&P500 6.57% 5.83% 17.72% 18.56% -5.19%
REFERENCE CAP 7.12% 6.15% 17.22% 17.79% -5.15%
BOOK 7.91% 8.36% 17.22% 16.44% 2.71%
INCOME 7.05% 8.60% 17.44% 17.42% 5.66%
REVENUE 7.70% 8.89% 18.28% 16.78% 6.85%
SALES 7.70% 8.95% 19.21% 16.67% 5.73%
GROSS DIV 6.30% 8.09% 18.63% 15.10% 6.13%
# EMPLOYEES 9.93% 8.65% 17.77% 15.66% 5.75%
COMPOSITE 8.15% 8.12% 19.09% 16.67% 5.32%

Value Added, by Decade
Excess Return by Decade 1962-69 1970-79 1980-89 1990-99 2000-03

S&P500 -0.55% -0.32% 0.50% 0.77% -0.05%
REFERENCE CAP - - - - -
BOOK 0.79% 2.21% 0.00% -1.35% 7.86%
INCOME -0.07% 2.45% 0.21% -0.37% 10.81%
REVENUE 0.57% 2.74% 1.05% -1.00% 12.00%
SALES 0.57% 2.79% 1.99% -1.12% 10.88%
GROSS DIV -0.83% 1.93% 1.40% -2.69% 11.28%
# EMPLOYEES 2.81% 2.50% 0.55% -2.13% 10.89%
COMPOSITE 1.02% 1.97% 1.86% -1.12% 10.46%

Results in Expansion & Recession, Bull &
Bear Market, Rising and Falling Rates
Returns, by Market &

Economic Bull
Environment Expansion Recession Market Bear Market Rising Rates Falling Rates
S&P500 11.77% 3.15% 21.21% -22.21% 18.21% 2.39%
REFERENCE CAP 11.66% 3.17% 21.25% -22.60% 18.23% 2.19%
BOOK 12.77% 5.47% 21.07% -17.73% 19.95% 3.04%
INCOME 13.29% 6.53% 21.69% -17.21% 20.48% 3.71%
REVENUE 13.42% 6.97% 22.03% -17.44% 20.64% 3.91%
SALES 13.33% 7.20% 21.94% -17.36% 20.54% 3.91%
GROSS DIV 12.33% 7.45% 19.71% -14.40% 19.55% 3.28%
# EMPLOYEES 12.78% 5.66% 21.24% -18.01% 19.77% 3.31%
COMPOSITE 12.95% 6.43% 21.19% -16.98% 20.15% 3.43%

all_asset_phil_02

Twenty Largest Holdings
on 12 / 31 / 2003
Market Capitalization: Fundamental Composite:

MICROSOFT 3.061% WAL MART 3.078%
GENERAL ELECTRIC 2.682% GENERAL MOTORS 2.436%
EXXON MOBIL 2.586% STANDARD OIL N J 2.080%
WAL-MART 2.452% GENERAL ELECTRIC 1.867%
PFIZER 2.081% AMERICAN INTERNATIONAL GROUP 1.839%
CITIGROUP 1.999% COMMERCIAL CREDIT CO 1.733%
JOHNSON & JOHNSON 1.761% MICROSOFT 1.170%
AMERICAN INTERNATIONAL GROUP 1.668% NCNB 1.134%
IBM 1.475% SOUTHWESTERN BELL 1.095%
MERCK 1.404% FNMA 1.052%
PROCTER & GAMBLE 1.235% STANDARD OIL CALIFORNIA 0.987%
BERKSHIRE HATHAWAY 1.234% BELL ATLANTIC 0.977%
COCA-COLA 1.197% FORD 0.962%
VERIZON 1.174% BERKSHIRE HATHAWAY 0.941%
BANK OF AMERICA 1.153% CHEMICAL NEW YORK 0.860%
INTEL 1.131% PFIZER 0.809%
CISCO 1.057% IBM 0.801%
SBC COMMUNICATIONS 0.994% MERRILL LYNCH 0.780%
PHILIP MORRIS 0.913% METLIFE INC 0.752%
WELLS FARGO 0.873% MERCK & CO INC 0.739%

Does the Fundamental Indexing Concept
Work Outside of the US?
(Japan Analysis Courtesy of Nomura Research Institute)
Methodology for Japan
 Universe : all stocks listed in Japan

 We used 4 measures of firm size:
• book value (“book”)
• trailing 5-year average operating income (“income”)
• trailing 5-year average sales (“sales”)
• trailing 5-year average gross dividend (“dividend”)
• We could not get sufficient data for total employment
 For each measure, we constructed an index

portfolio as of for each year from 1980 to 2004.
• Each portfolio includes top 1000 stocks.
• Each stock is weighted by each measure.
• Each portfolio rebalanced as of January 1st
• also tested for rebalancing July 1st; very similar results
© 2004 Research Affiliates, LLC and Nomura Securities. Patent Pending. All rights
reserved. Duplication or dissemination prohibited without prior written permission. 45
Composite Methodology
 The composite measure of each stock’s size is

the average of the weights in the four portfolios.
 The top 1000 stocks on the composite measure
are selected.
 The composite index is created using this
composite measure for the index weights.
 For comparison purpose, we also constructed a
cap-weighted market index (“cap”) using the
same method.
Cumulative Performance (January Rebalance)
cumulative performance (J an.)
8 book
opincm
sales
7 dividend
composite
cap
6
TOPIX
0
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
79
80
83
84
85
88
89
90
93
94
97
98
99
02
03
81
82
86
87
91
92
95
96
00
01
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
19
19
19
19
19
19
19
19
20
20
Performance (January rebalance)
Value-Added versus TOPIX Index
cumulative performance (ratio to TOPIX, J an.)
book
1.8
opincm
sales
dividend
1.6 composite
cap
1.4
1.2
0.8
0.6
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
12
80
84
85
88
89
93
94
97
98
02
03
79
81
82
83
86
87
90
91
92
95
96
99
00
01
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20
19
19
19
19
Performance (January rebalance)
performance (198001 - 200407)
J an. (annualized)
book opincm sales dividend composite cap TOPIX
geometric return 6.235 5.842 5.593 6.320 6.001 3.809 3.630
volatility 18.180 18.142 20.128 18.278 18.530 18.636 18.737
Sharpe ratio * 0.343 0.322 0.278 0.346 0.324 0.204 0.194
CAPM beta * 0.945 0.922 1.002 0.939 0.954 0.993 1.000
correlation 0.974 0.952 0.932 0.963 0.964 0.999 1.000
excess return 2.604 2.212 1.963 2.690 2.370 0.179

tracking error 4.240 5.737 7.278 5.088 4.977 0.913
turnover 24.274 27.496 21.299 23.098 23.199 6.600

* The risk free rate is not subtracted
Notes
 We used consolidated data if it was available, and if not, we

used parent data.
 We calculated “trailing 5-year average” if data had at least
one-year history.
 “Geometric return” is defined by arithmetic mean of log
return.
 We also simulated under the following conditions and
found no significant differences.
• Universe = TSE1
• No constraint for the number of stocks -- all stocks included in the
index
Sector Allocation Stability
Sector Weights Over Time,
Capitalization Weighting
100%
90%
80%
70%
Portfolio Composition
60%
50%
40%
30%
20%
10%
0%
1962.01 1965.01 1968.01 1971.01 1974.01 1977.01 1980.01 1983.01 1986.01 1989.01 1992.01 1995.01 1998.01 2001.01
Other Retail non-Dur Dur Chem Elec. Eq. Telcom Util Health Manu Energy Finance

Sector Weights Over Time,
Fundamental (Composite) Weighting
100%
90%
80%
70%
Portfolio Composition
60%
50%
40%
30%
20%
10%
0%
1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001
Other Retail non-Dur Dur Chem Technology Telcom Util Health Manu Energy Finance

Concluding Observations
Are the Cap-Weighted Indexes Efficient?
Are Fundamental Indexes Better?
 No, Cap-Weighted Indexes are Not Efficient

• Incomplete; No market portfolio exists; fails SEMH paradox
• Maybe market clearing is irrelevant in such a narrow context
 Yes, Fundamental Indexes are Measurably Better
• Observably higher return and lower risk
• Survives the Super-EMH paradox
• Introduces no obvious negative structural alpha
• Spans same market as cap-weighted index, only better
• “You can have irrational exuberance in prices, but not in
revenues or employees”
 Still, not without weaknesses
• No longer meets the “market clearing” condition for CAPM
• Other ideas may be developed which are still more MVE
55
Where Do We Go From Here?
 May work as well within segments and sectors

 Should work as well in other markets (bonds? other
countries?), for same reasons
 May work still better for international & global portfolios
 Outpaces active managers more reliably than it outpaces
capitalization-weighting
 Fundamental Index – Capitalization Index may be sound
basis for Market Neutral application
 Very Important Risk Premium Implications
 Are Fundamental Indexes even better than they seem?
56
Where Do We Go From Here?
Patent Pending
© 2004, Research Affiliates, LLC
Use of the indexes in this presentation without

expressed written permission is prohibited.
Regarding commercial use of the indexes in this

presentation contact Research Affiliates, LLC.
57

Reexamining The Market Portfolio: Have Our Equilibrium Models Been Misspecified?

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Reexamining the Market Portfolio:

Have our Equilibrium Models been Misspecified?

Chicago Quantitative Alliance

 “The essence of investment management is the

 “Investing is a “loser’s game,” in which the

 Stocks: 3.0% real IRR; 0% real 5-year return

Real Stock Returns (erring on the high side?)

1.8% 2.7% 1.5% 3.0%

Real Bond Returns

Current Risk Premium is Very Weak …

for stocks relative to inflation-indexed government-

The simple fact is that

 Consider Other Asset Classes

 Fourth Path, Leverage, Increases Risk and Exposure to

 Suppose we have something better than strong-form EMH

 Theory does a Marvelous Job explaining how the

 Passive, requiring little trading

 How do we construct an index that strips away

• Note that Style Indexes Screen by Style – then Weight by Capitalization.

© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

Excess Excess CAPM Tracking

Excess Excess CAPM

Excess Weighted $ Weighted

Excess Excess Ret. Each Way

 Do Fundamental Indexes capture something

 Is a “Fundamental Index” an index? Sure.

Growth of $1.00 from 1/1/62 through 12/31/03

S&P 500 Book 1000 Revenue 1000 Cap 1000

© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

Growth of $1.00 from 1/1/62 to 12/31/03

Growth of $1.00 from 1/1/62 to 12/31/03

© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

Growth of $1.00 from 1/1/62 to 12/31/69

S&P 500 Book 1000 Revenue 1000 Cap 1000

© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

Growth of $1.00 from 1/1/70 to 12/31/79

S&P 500 Book 1000 Revenue 1000 Cap 1000

© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

Growth of $1.00 from 1/1/80 to 12/31/89

S&P 500 Book 1000 Revenue 1000 Cap 1000

© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

Growth of $1.00 from 1/1/90 to 12/31/99

S&P 500 Book 1000 Revenue 1000 Cap 1000

© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

Growth of $1 1/1/2000 to 12/31/2003

S&P 500 Book 1000 Revenue 1000 Cap 1000

© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

Performance by Decade 1962-69 1970-79 1980-89 1990-99 2000-03

© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

Excess Return by Decade 1962-69 1970-79 1980-89 1990-99 2000-03

© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

Returns, by Market &

© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

Duplication or dissemination prohibited without prior written permission. 42

Market Capitalization: Fundamental Composite:

© 2004 Research Affiliates, LLC. Patent Pending. All rights reserved.

 Universe : all stocks listed in Japan

 For each measure, we constructed an index

 The composite measure of each stock’s size is

cumulative performance (J an.)

performance (198001 - 200407)