The Fundamental Index™ methodology involves rebalancing and, in so doing, largely avoids bubbles and profits from anti-bubbles. Annually anchoring on fundamental size, the RAFI methodology trimmed the tech and media darlings leading up to the bear market of 2000–2002.4 As value stocks relentlessly beat growth in the middle part of the decade, the RAFI methodology systematically reduced its weight to these repeated outperformers resulting in a smaller and smaller value bias, right before value fell off a cliff. Then, in the great contra-trade of 2009 (see the April 2009 issue of Fundamentals… we called it as it was happening!), the RAFI methodology bought into the unloved deep value names and reduced exposure to the beloved safe havens and growth stocks.
Which is Clairvoyant?
We often are asked why we would want to ignore all the valuable insights regarding a company’s future prospects that are embedded in the price of a stock. After all, the market cap is based on share price which reflects the consensus of millions of investors as to the fair value for a company. Our reason, quite simply, is that these insights are already in the price: if a company’s share price is high or low because its prospects are brilliant or bleak, the share price is already discounting those consensus expectations. The future risk-adjusted returns for these companies will be identical, absent any shocks that are not already reflected in the share price!
In principle, then, cap weight ranks ought to predict future direction for economic scale ranks. That is, if a company is ranked lower by cap weight than by economic scale, the market is suggesting that it should shrink in the years ahead. However, the reciprocal does not hold true: assuming that cap weight incorporates all current information about future prospects for a company, if a company is ranked higher or lower by economic scale than by cap weight, this should tell us precisely nothing about whether the cap weight rank is headed higher or lower.
How does this work out? Both are clairvoyant!
For instance, in 1960, Gulf Oil and Mobil (called Socony Mobil at the time) were on the Fundamental Index top 10 list, but neither made the top 10 list by market cap. So, the cap-weighted market was saying that they were going to shrink. They did. They fell off of the Fundamental Index top 10 list in the next five years. During the 50 years, there were 64 instances in which the cap weight rank and the Fundamental Index rank differed, and in which the Fundamental Index rank changed in the next five years. In 46 cases (72%), the difference correctly predicted the next change in Fundamental Index rank, and in 18 cases (28%), cap weight had it wrong.
Turn it around. Does the Fundamental Index rank predict the next change in cap weight rank? Yes, it does. There were 76 cases in which the cap weight rank and the Fundamental Index rank differed, and in which the cap weight rank changed over the next five years. In 49 cases (64%), the Fundamental Index rank predicted the change in the cap weight rank, while in 27 cases (36%), the Fundamental Index rank got it wrong.
How is this possible? Suppose the correct rank is between cap weight rank and Fundamental Index rank. In other words, suppose the market cap is clairvoyant in picking winners and losers, but overpays for the winners. Then, we’d get exactly this outcome. This dovetails perfectly with the work that we published on the topic of Clairvoyant Value in the Journal of Portfolio Management this past summer.5
Will Rogers once quipped, “Popularity is the easiest thing in the world to gain and it is the hardest thing to hold.” The box load of clothes we donate to charity every few years can attest to how quickly something can go from all the rage to yesterday’s news. For all but a few, fame and favor is fleeting. This holds true for fashion and stocks. The top of the capitalization index is filled with companies at the height of their popularity and, judging by the amount of Fallen Angels, due for a fall.
In contrast, the Fundamental Index approach is immune to how popularity pushes select stocks’ prices—and portfolio weights—into the stratosphere. Consider it the classic blue blazer, the khaki dress slacks, or the little black dress. None will land on the cover of GQ or Vogue but all will likely stay in your closet for a long time, saving you and your wallet from chasing fads, crashes, and bubbles.