kyounge1956
Thinks s/he gets paid by the post
- Joined
- Sep 11, 2008
- Messages
- 2,171
Good thread,
By "factor exposure" Bernstein means that certain factors (e.g. smallness or book-value ratio, a way of classifying something on a value-growth continuum) have been shown through repeated historical research to generate excess returns which most researchers agree accrue to the additional risks such companies face. (Small stocks are perceived to be riskier possibly because they can get cut off from credit during a credit crunch or value stocks are perceived to be risker because they are (often) companies whose stock prices are beat up because something has gone wrong with the business)
So what Bernstein is saying (and I agree) is that any outperformance by these fundamentally-ranked portfolios may only be the expected return for the additional risk they are taking on by having more small or value in their mix than the S&P
This may be just what you want, but it isn't a magic bullet way to earn a free lunch, extra return for no additional risk.
Also, as someone said in this thread, people have been putting similar portfolios together for years without Arnott's indexes by using small and value-tilts.
One trivia footnote --I worked for Arnott years ago (1982,83) when he was a portfolio manager at the Boston Company and I was a programmer pulling together the screens through the historical CRSP and Compustat data to look for things that would produce excess returns... I can assure you people have been looking for ways to mine that data to find a magic formula for a really long time. If anything gets found, the advantage tends to get traded away in a hurry. Made me into a lifelong slicer/dicer indexer...
I think the book is only claiming that a fundamentally weighted broad-market basket of stocks will significantly outperform a cap-weighted broad market basket. Using a "value" screen would eliminate the overpriced stocks from the mix, so it doesn't surprise me that the performance of a value index is similar to a fundamentally-weighted broad-market index. In fact it wouldn't surprise me if the value-screened basket outperforms the fundamentally-weighted stocks, because the value screen would remove overpriced bubble stocks from the portfolio altogether, while fundamental weighting only assures that they don't increase in proportion to the whole.
There are both mutual funds and ETFs based on fundamental weighting. The expense ratios I saw for a fundamentally weighted index of large US stocks, large international stocks and small/medium US were all lower than 1%, so the cost to implement fundamental indexing is less than the benefit when compared to a cap-weighed broad-market index, but I can easily imagine (though I haven't checked) that when compared to a cap-weighted, value-screened index fund, the cost might be greater than the benefit. Implementation of fundamental weighting requires inclusion of three characteristics in addition to the one the value index uses, and there would also be some additional trading required for reasons already mentioned earlier in the thread. I would guess that in the raw numbers, a fundamentally-weighted, value-screened basket of stocks would outperform the same basket with cap-weighting (but maybe not by a statistically significant amount), but that when the expense of implementing the fundamental weighting is included the cost would exceed the benefit.