The authors describe in detail how the RAFI index methology works and answer also many critisism to their approach. What is still missing is a significant real track record (they mix proforma and actual results, unfortunately). It also shows clearly the shortcomings of the current marketcapweighted indices. In short: Very important subject but maybe too many pages for one idea.

Arnott claims his fundamental index historically gives a 2% improvement in return compared to conventional cap-weighted indexes [page 263 from 1962-2007 with S&P 500 with a return of 10.3% and sigma of 14.6%.........and his RAFI U.S. Large with a 12.3% return and sigma of 14.4%]. Arnott also says the RAFI returns shown in the appendix are before expense ratios are applied [p. 262]. Some RAFI funds have expense ratios of 0.75%. If you assume a typical Vanguard conventional mutual fund ER of 0.2%, then the fundamental index advantage in U.S. large caps falls from 2% to 1.65% [S&P 500 return of 10.3% - Vanguard ER of 0.2% = 10.1%........and RAFI return of 12.3% - ER of 0.75% = 11.55%.......gives a 1.45% advantage to RAFI]

Many critics of Arnott claim his fundamental index is really just a value tilt and investors could achieve the same value tilt with typical Vanguard low 0.2% ERs versus Arnott's high 0.75% ERs (of course Arnott would not get rich from his cut of the 0.75% ER if investors just value tilted using Vanguard funds).

The only historical returns data set I have available to me runs from 1972 to 2007. I calculated the historical returns from 1972 to 2007 assuming actual Vanguard expense ratios and the RAFI index having a 0.75% ER. I got the annual RAFI U.S. Large returns before expense ratio fees from the appendix of Arnott's book. I got the Vanguard fund returns from the Excel sheet referenced on the Bogleheads web site [Bogleheads dot org].

Fund Name...................Symbol..............1972-2007 CAGR...RAFI comparison

RAFI U.S. Large.............n/a...................12.88%

Vanguard Index 500........VFINX...............10.91%.......1.97% less than RAFI

Vanguard Large Cap Value...VIVAX...........12.94%......0.06% more than RAFI

Vanguard Small Cap Value....VISVX..........14.15%......1.27% more than RAFI

Arnott only provides data in his book on his RAFI international from 1984 to 2007. Comparing RAFI international to Vanguard's international value fund gives:

Fund Name...................Symbol..............1984-2007 CAGR...RAFI comparison

RAFI International..........n/a...................14.09%

Vanguard Intern'l Value....VITRIX............13.82%....0.27% less than RAFI

From this historical returns data, it appears the pundits of Arnott's theory are correct: Ordinary investors could achieve the same results as Arnott's fundamental indexes by simply tilting their portfolios towards value index funds.

Arnott claims the largest return advantage using fundamental indexing occurs in emerging markets.....with a 10.7% advantage from 1994-2007 [page 281]. Unfortunately, Vanguard does not offer an emerging markets value fund to compare to Arnott's RAFI index.

One could speculate on how to come up with a snazzy new index in which you could collect a licensing fee for use of the index...using the following questions and answers:

Q: What determines the return of stocks?

A: Fama and French showed that returns are a function of style (value versus growth) and size (small versus large)

Q: How could we create our snazzy new index based upon F&F's work that showed that value stocks have higher returns than growth stocks?

A: We could base our snazzy new index on typical value indicators of company....like dividends, sales, cash flow, book value.

Q: These 4 typical value indicators are not very exciting and are well known...with book value dating back to the 1930's with Benjamin Graham. How could we make this sound more exciting to the average investor?

A: We call these 4 typical value indicators Main Street versus Wall Street indicators.....this will appeal to the average Joe.

Using the above Q & A's as a line of thought........we now have a snazzy new index name called Fundamental Indexing and an appealing story of using Main Street versus Wall Street indicators to rank the stocks in the fund. We can claim the idea is revolutionary and we are therefore justified in charging high expense ratios to use the new index.

The one RAFI index that might be attractive to ordinary investors is his Emerging Markets index. Historical data has shown a 10.7% advantage over conventional emerging markets index funds. Vanguard does not offer an emerging markets value fund, so this asset class is not easily accessible to investors. DFA does offer an emerging markets value fund, but you can only buy them through a DFA advisor with a typical 1% fee. The relatively high 0.85% ER for the Powershares PXH fund might be worth it to try to capture some of the 10.7% return given there are no other ways to easily invest in this asset class.


Over-all, this book is easy to read. Time will tell if Arnott's fundamental indexes outperform value based cap-weighted index funds net of expenses.

Other books which are based upon traditional cap-weighted index fund investing are shown below:

Index Mutual Funds: How to Simplify Your Financial Life and Beat the Pro's
The Richest Man in Babylon
Bogle on Mutual Funds: New Perspectives for the Intelligent Investor
The Millionaire Next Door
The Four Pillars of Investing: Lessons for Building a Winning Portfolio
A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, Ninth Edition
The Coffeehouse Investor: How to Build Wealth, Ignore Wall Street, and Get On With Your Life
The Bogleheads' Guide to Investing

This book written by the strongest advocate practitioner (Arnott) of Fundamental Indexing (FI) is well written. But, you should not confuse a FI manifesto for a balanced analysis on FI vs Market Cap Indexing (MCI). Arnott goes as far as stating that FI has redefined the entire investment Efficiency Frontier (pg. 241) as for any level of risk, he believes FI earns a higher return. And, for any level of return FI reduces your risk. To his credit, Arnott does a good job of addressing the main critiques against FI in chapters 10 and 11. However, for more challenging FI rebuttals, I recommend the articles by Paul Kaplan and Andre Perold.

The logical advantage of FI is unclear. In the Foreword, Harry Markowitz makes an example with a two stock portfolio and shows how stock mispricing will cause MCI to be over weighted in the overpriced stock. When such a stock reverts back to its fair value, MCI suffers a return drag vs FI. But, Andre Perold using Bayesian analysis, takes apart this exact same example because you don't know beforehand which stock is over valued. To further confuse things, Arnott early in the book (page 38) contradicts himself. He states that a MC index does not have a negative Alpha. But, capitalization weighting does. That's not possible. Either they both incur negative Alpha, or they don't (besides the minor cost difference). Later, on page 208 according to his own analysis, Arnott recognizes that with large caps only 1/3 of the FI value added comes from its actual structure. The other 2/3 come from small cap and value tilts.

To clarify this issue, I will review: a) what I expect the difference between FI and MCI to be, b) the historical records, and c) the FI outlook.

Because FI is under weighing growth stocks, I expect it outperforms during Bear markets and underperforms during Bull markets. Because Bull markets are much longer than Bear ones, I expect FI to earn lower returns but with lower volatility. On a risk-adjusted basis the two should earn equivalent returns. When factoring FI higher turnover resulting in higher operating costs and taxes, MCI should come out slightly ahead.

FI historical back tested records are very impressive. Contrary to my expectation, over the 1962 to 2007 period FI outperformed MCI in Bull markets (by a small margin). And it killed MCI by several percentage points in Bear markets. Overall, FI beats MCI by 2 percentage points p.a. (for large cap) while incurring the same risk (same standard deviation). FI beats the MCI for just about any segment of the equities market: large cap, small cap, value, growth, international, country specific (pg. 123), emerging markets, and REIT. The FI advantage increases from 2% to up to 6% as you move into less efficient markets such as emerging markets. Such historical results are not entirely explained simply by FI smaller cap and value tilt. Any higher return is usually associated with much higher risk (but not for FI). Also, FI beats MCI when focusing on either value or small cap stocks only. Thus, something is going on besides small cap value tilt. Arnott states FI superiority is due to the inefficient allocation of MCI that overweighs the growth stocks that suffer the worst returns in Bear markets. But, FI under weights this same growth stocks during Bull markets. What the FI gains during Bear markets, it should give back during Bull markets. But, it did not. It beat the MCI during Bull markets too. The few times the FI fell behind is during short bubbles such as the late 90s dot.com bubble.

Actual live performance of FI funds has been so far not impressive. This contradicts the author's assertion on page 176. That's because my data set extends another 7 months since the book was published. I investigated the two RAFI funds with available public records: RAFI US 1000 (PRF) covering large caps started in December 2005 and RAFI US 1500 (PRFZ) covering smaller firms. The funds history is short, but is a good test as it captures a Bear Market that started in May 2007. Thus, I would expect the RAFI funds to do better than their MC index fund counterparts. I compared PRF and PRFZ with the traditional index funds most correlated with them, respectively Vanguard Large Cap Value (VIVAX) and Vanguard Small Cap Value Index (VISVX). Since inception the RAFI funds have earned the same return (essentially zero) while incurring the same volatility vs their traditional index counterparts. Since May 2007 (beginning of Bear Market), PRF return is - 23.1% vs - 22.7% for VIVAX. (PRF did a bit worst than VIVAX). Meanwhile PRFZ return is - 20.3% vs - 21.9% for VISVX. (PRFZ did better than VISVX). In both cases, those RAFI funds way underperformed a plain total stock market index fund, especially in a Bear market. This short term track record, especially in a Bear market that should favor RAFI funds, does not give you confidence that such funds will duplicate the impressive historical back tested record.

Paul Kaplan suggests already the next step: MCI with boundaries delineated by certain multiple of fundamentals. He calls this a collared index. When a specific stock would bubble its weight within the portfolio would be reduced by the delineated fundamentals boundaries. By doing so you would preserve the advantages of MCI (low cost, diversification) while avoiding excessive concentration in over heating stocks (FI advantage). I hope Kaplan puts this concept into practice.

If you find this book interesting, I recommend the following books that also defy existing investment theory: Market Volatility, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, and The Misbehavior of Markets: A Fractal View of Risk, Ruin & Reward. If you want to better understand what traditional investment indexing is about, I recommend the classic A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, Ninth Edition.

First of all, a market portfolio is holding capitalization-weighted stocks. So when Arnott says his "fundamental indexing" beats a cap-weighted portfolio (like on p. 160), he's simply making the same argument active managers make when they say they can beat the market.

It's important to note too that a fundamental index is only a fundamental index once per quarter. These things don't rebalance daily, folks. Even with quarterly rebalancing though, the turnover is higher than with cap-weighted index funds or ETFs. So that's one cost that fundamental indexing must overcome.

The other thing to point out is merely with the fact that more oversight and work is required on the part of the fund company, the expense ratio will be higher than a completely passive cap-weighted index fund. Are the higher fees worth the bet you're making on this strategy?

If markets are truly efficient, then cap weighting is the way to get the market rate of return. Anything else is almost by definition an active or quant (which is what fundamental indexing is) bet.

Your best bet as an investor is to skip the hype and go for the market rate of return.

With all that said, I do still recommend this book to further your investment education. I give it 4 stars out of 5.

I believe the book is a must read for professional investors as well as non-professionals, advisors, trustees and most certainly the academic community. It offers a (deceptively) simple explanation to a series of widely debated issues in modern portfolio construction. While I wouldn't dare entering into a debate with any of the rather well-known critics of the concepts I would propose that they all read the book carefully and contemplate the principle known as Occam's razor while doing so; "Occam's razor (sometimes spelled Ockham's razor) is a principle attributed to the 14th-century English logician and Franciscan friar William of Ockham. The principle states that the explanation of any phenomenon should make as few assumptions as possible, eliminating those that make no difference in the observable predictions of the explanatory hypothesis or theory." (Quote from Wikipedia) The Fundamental Index concept as such may not be new, other will have to be the judge of that, but at least I know of no other formalization of the concept, nor of any other text offering the richness in its explanations of the sources and applications of the concept. (Disclosure: I am on record as being a supporter of the concept and I work for a firm that is a Research Affiliates, LLC, licensee.)

Watch Video Here: http://www.amazon.com/review/R13S4FN7LU8QHY

This book contains a good overview of the basic arguments for and against The Fundamental Index in a very readable format. For those who have followed the debate in the finance journals, there will be little new here and the book does not address the formal mathematical models of Fundamental Indexing that have been introduced in various papers from Arnott & Hsu. However, the data and arguments are well organized, with the book proceeding from an introduction of the concept, through the historical data and ending with a balanced overview of the arguments for and against.

The book is more than just a pitch for a particular investment strategy, the issues raised in The Fundamental Index touch upon the empirical foundations (or lack thereof) of Modern Portfolio Theory and will force any investor, regardless of whether they use the approach or not, to think more carefully about their basic assumptions about the equity markets.

For a layperson looking for depth and insight into the equity markets, this book would make an excellent supplement to a more general work such as Burton Malkiel's Random Walk Down Wall Street.

The Fundamental Index is a must-read for serious investors. The authors make a compelling case for the use of fundamental index products in a portfolio designed to outperform its benchmark. I was impressed that the authors devoted two full chapters (10 and 11) to addressing opposing arguments. I found Chapter 13 especially useful, as it contains 10-year return forecasts for bonds and equities from one of the world's leading asset allocators. I was so impressed with the quality of the book that I have since purchased a number of copies to share with other investors.

I am a relatively well known fan of the fundamental index approach. Rob and his co-authors have a great turn of phrase which makes this book a pleasure to read. The discussion of how the value/size tilt is a result of contrarian against the cap weighted index is particularly insighful. I know Cliff doesn't approve, but I can't help but be impressed when someone offers a really cheap way of investing in a sound strategy.
To my mind this is a book that all inveswtors hsoudl read, be they active or passive. Regardless of the way in which you invest, you should find something to make you think in this excellent tome.

A must read for all investors! I love it!

I personally believe in active management. The market consists of human beings with many imperfections. If we are wise enough, we could certainly take advantage of investors' irrational behavior, and thus earn excess returns. Unfortunately from the investment practice, very few active fund managers, like Warren Buffett, can consistently outperform the market indices over the past decades. It is a difficult task to delivery Alpha.

Mr. Arnott and his colleagues show us that The Fundamental Index is a better way to invest, and could consistently outperform the traditional cap-weighted market indexes. To my surprise, The Fundamental Index is a very simple and intuitive idea which works from developed markets to emerging markets. What's more, the outperformance of the Fundamental Index is statistically significant, economically large, and can be theoretically expected. For example, The Fundamental index (RAFI) US large portfolio outperforms the cap-weighted S&P 500 Index by 2% annually over the period from 1962 to 2007. The emerging-market fundamental Index portfolio outperforms the cap-weighted MSCI EM Index by more than 10% annually over the period from 1994 to 2007. Imagine that, if we can consistently deliver an Alpha by 2% annually, over a 36 year period, we would double our assets! (Not to mention a 10% Alpha over a 13 year period!)

The Fundamental Index preserves the virtues of the cap-weighted index such as transparency, diversification, low turnover and high capacity, but overcomes the price inefficiency problem. The cap-weighted index portfolio tends to systematically overweight the overpriced stocks and underweight the underpriced stocks. That is the reason why the Fundamental Index outpaces. I am so excited that Mr. Arnott can share the investment Holy Grail with all investors. I deeply believe that "the Fundamental Index idea will be the fastest new investment idea to reach $100 billion in assets in history!" I strongly recommend that every investor should read this book.

Rob Arnott and his team have created a value-added product for investors. Picking up on Jack Bogle's idea that indexing is the superior way for the average person to invest, Arnott has created an approach to indexing that adds even more value than a passive approach. Highly recommended with plenty of important insights.
Jim Ware, CFA, co-author of "High Performing Investment Teams"

This book makes a compelling case to consider another way to give investors a broad market exposure at low cost and low turnover, other than cap-weighted indexing. It does not argue that there is no role for active investment, but that it is extremely difficult to find active investors who can outperform consistently over time.

Index investors have always faced a dilemma: they know that on average, active investment management will underperform a cap-weighted index, after allowing for fees. But cap-weighting a portfolio leads to more money weighted towards more expensive stocks, and less towards cheaper stocks, due to the direct link to price. As the market corrects towards the intrinsic value of the stocks, the portfolio will suffer.

The book proposes a method which weights stocks based on their economic fundamentals, such as sales, book value and dividends, rather than market price, and the results show consistent outperformance.

I find this such a compelling and simple idea, and the book provides enough evidence for the most academic and thoughtful market participants to wade into the debate.

Take a simple example (this is my own, not from the book). A restaurant owner knows things like total sales, expenses and cash flow, and can tell how well it is doing, and the value of the business. However, if it was a listed company, its value would be reacting to market rumours on staff leaving, perceptions of the effect of a wet summer, reports on potential competitors, criticims of the food, whatever. And the market would trade the stock based on all these factors which may or may not have an impact on the intrinsic value. Yet a cap-weighted index would hold the stock based on rumour and guesses about the future. I'd rather just use the economic fundamentals of the business.

It is difficult to refute the book's argument that a cap-weighted index has a direct structural link to any pricing error, and since the true value of a stock is the net present value of decades of future cash flows, which must be unknown, there must be pricing errors. The market is not efficient, as it cannot know everything. As these errors will be random, the cap-weighted index will have more than half the portfolio in the overvalued companies, and less than half in the undervalued companies, because the weight is linked to the price. I found this conclusion especially revealing.

The only time when a cap-weighted index may outperform a fundamental index is during a major bull run, such as 1999, when growth stocks are continuously marked up. However, this is when I least want to put more into the expensive growth stocks, which cap-weighting does.

This book is not an academic exercise, despite the backgrounds of its authors, but is easy to read and understand. It illustrates its points with examples we can all identify with, and directly addresses the criticisms of its approach with a degree of humour. It certainly delivers a few 'ah-ha' moments.

If I have one general criticism, it is that a relatively simple idea takes 300 pages to address. I'm sure this is because the authors are producing the first comprehensive book on an idea which could seriously change investing markets, and they try to cover all bases. But I did felt like saying, "Yes, I already got that" a few times.

With most investments actively managed and the rest in cap-weighted indexes, the ideas in this book challenge orthodoxy. But that's always a good thing.

As a public critic, and former, and hopefully future, friend of the authors, I received a signed copy of the book with a note (excerpting) "Some day I hope we'll win you over!" The note went on to extol the power of their approach, and showed they have not been listening to anything I've said.

My point has consistently been that I do not need to be won over, rather I, and many (so many) others, have been researching and doing this type investing for at least 20 years before the Fundamental Indexers came along, re-discovered it, and re-labeled it their own. I have never had a problem with their core strategy, as it's a core that is mostly value with some small cap investing as a way to beat a market-cap index. It's an active quantitative value strategy, and, like many others, I've been writing and talking about this strategy for years. Rather it is they who have been won over by the literature they've borrowed, and now are attempting to take over (the way the Mongols were "won over" by China).

This book (which I admit have NOT read, I have spent too much of my life on this already! - plus casual observation shows it's a collection of the same stuff I've read many times) may give more credit where it's due (I hope it does), but it's too little too late. Fundamental Indexing may be a reasonable investing strategy (though why, if you believe in inefficient markets, you'd stop here when other effects like momentum have also been documented in the literature are beyond me), but it's repeated description as something new and revolutionary, up to and including this new brightly colored book, will not "win me over" to something I (along with so many others) was convinced of long before the authors.

Of course, if I'm pleasantly surprised and the book does give the proper credit to those who have come before them, I'm not sure what would be left for them to talk about?

As a public critic, and former, and hopefully future, friend of the authors, I received a signed copy of the book with a note (excerpting) "Some day I hope we'll win you over!" The note went on to extol the power of their approach, and showed they have not been listening to anything I've said.

My point has consistently been that I do not need to be won over, rather I, and many (so many) others, have been researching and doing this type investing for at least 20 years before the Fundamental Indexers came along, re-discovered it, and re-labeled it their own. I have never had a problem with their core strategy, as it's a core that is mostly value with some small cap investing as a way to beat a market-cap index. It's an active quantitative value strategy, and, like many others, I've been writing and talking about this strategy for years. Rather it is they who have been won over by the literature they've borrowed, and now are attempting to take over (the way the Mongols were "won over" by China).

This book (which I admit have NOT read, I have spent too much of my life on this already! - plus casual observation shows it's a collection of the same stuff I've read many times) may give more credit where it's due (I hope it does), but it's too little too late. Fundamental Indexing may be a reasonable investing strategy (though why, if you believe in inefficient markets, you'd stop here when other effects like momentum have also been documented in the literature are beyond me), but it's repeated description as something new and revolutionary, up to and including this new brightly colored book, will not "win me over" to something I (along with so many others) was convinced of long before the authors, we just gave proper credit to those before us.

Of course, if I'm pleasantly surprised and the book does give the proper credit to those who come before them, I'm not sure what would be left?