January 13, 2009
The latest versions of the claim
In a debate in the recent Journal of Indexing between Paul Kaplan, vice president of quantitative research at Morningstar, and Robert Arnott, chairman and founder of Research Affiliates—a fundamental indexing advocate—Arnott advances two versions of the standard claim. The first is devoid of meaningful content, but sounds reasonable and paves the way for the second version which is simply wrong.
The first takes this form: “[E]very stock that’s trading above its eventual fair value is weighted in the cap-weighted portfolio above that eventual fair value weight, and every company that’s below its fair value is below its fair value weight. If you can just randomize those errors, that does add value.”2
The first sentence is a tautology, devoid of meaningful content. It says that every stock whose price is greater than its fair value has a price above its fair value, and every company whose price is below its fair value has a price below its fair value. I challenge anyone to find more in it.
Then what can this mean: “If you can just randomize those errors, that does add value?”
The second claim is: “If we have a cap-weighted portfolio, we know most of our money is in companies that are above fair value, whether they’re high or medium or low valuation multiples. We know that they’re going to revert toward fair value over time. And so we know that most of our money is in assets that are going to under-perform and too little is in assets that are going to outperform.”3
But it is obviously wrong to say that “If we have a cap-weighted portfolio, we know most of our money is in companies that are above fair value.”
Consider a two-company world. Company A has a fair value of $10 billion with a market value of $9 billion, and Company B has a fair value of $5 billion with a market value of $6 billion. If we have a $150,000 market-cap-weighted portfolio, it will have $90,000 in Company A, the undervalued company, and $60,000 in Company B, the overvalued company. It will not have most of its money in companies that are above fair value—it will have most of its money in the company that is below fair value.
It remains only to wonder why these arguments—which imply claims to mathematical (rather than merely empirical, historical) superiority for fundamental indexing—have received any attention.
2 Journal of Indexes, January/February 2009, page 31. Available here.
3 Ibid., page 33.
Display article as PDF for printing.
Would you like to send this article to a friend?
Remember, if you have a question or comment, send it to .
