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 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 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.
As the United States 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, 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 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.
In a 2007 interview in the Journal of Indexes, Fama said they simply capture the “value effect” by using measures such as cash flow to select cheaper equities, not unlike what stock pickers do. In an e-mail in April, Fama said of Arnott’s work, “My view hasn’t changed.”
In his office in Newport Beach, Calif., where he keeps a first edition of Adam Smith’s “The Wealth of Nations,” from 1776, Arnott says he enjoys dueling with adversaries.
“I thrive on the controversy,” he says, smiling behind his neatly trimmed goatee. “Intellectual sparring is wonderful fun.”
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