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Weight by Fundamentals, Not by Price

Robert “Rob” Arnott is the chairman and chief executive officer of Research Affiliates. He has published many research papers, served as the editor in chief for the Financial Analysts Journal and pioneered several unconventional strategies, including the Fundamental Index approach. We spoke recently about his quantitative approach to managing stock portfolios.
—Charles Rotblut

Charles Rotblut (CR): Given your background in quantitative analysis, what suggestions could you give individual investors regarding stock characteristics and ratios that lead to better returns?
Robert Arnott (RA): The characteristics that historically produce the best returns are value measures. A higher yield does deliver a higher return and a lower price-earnings ratio delivers a higher return. One of my favorites is a lower price-to-sales ratio. While largely ignored, it does deliver a higher return.

To me, the more important opportunities are not so much in individual stocks as they are in portfolio construction. Typically when you buy a stock, the size of your investment in that stock drifts up and down with price—the higher the price, the higher the weight of the stock in your portfolio. That’s also the Achilles’ heel of market-capitalization-weighted index funds. So reweighting the portfolio to mirror the economic footprint of the business—something we call the Fundamental Index approach—weights companies by the fundamental size of the business and not by the popularity or price of the stock. This turns out to add a lot of value, partially because you’re trading against the market. As the stock’s price soars, if the underlying fundamentals aren’t soaring, if the company isn’t actually getting bigger, then a Fundamental Index portfolio will prompt you to sell some of what you own.

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