From Grant Wasylik, chief analyst, The Palm Beach Letter: His company developed strategies supporting $177 billion in assets… He’s a pioneer in the investment industry… a world-renowned lecturer on asset allocation… and he’s been dubbed the “Father of Fundamental Indexing.”

Rob Arnott is the chairman and CEO of Research Affiliates. The company examines new approaches to asset allocation, indexation, and other types of investing strategies. I met with him at last month’s “Inside ETFs” conference. It’s the largest exchange-traded fund (ETF) investment conference in the world.

Grant met with the legendary Rob Arnott at the 8th annual “Inside ETFs” conference (the world’s largest ETF conference) last month.

  Arnott believes investors are better off in traditional index funds than actively managed funds. That’s not surprising. As I noted in last week’s article on the conference, ETF investors enjoy greater diversification, lower fees, and higher returns than actively managed funds. But he thinks there’s a better way for investors to “index”…

Fundamental indexation: Fundamental factors such as sales, dividends, and cash flows are a far more accurate representation of value than just the market capitalization of companies.

[Market capitalization (or “market cap”) is the current stock price times the total number of shares outstanding.]

Arnott says his strategies add an extra 2% return to regular global indexing (back-tested over 48 years). He argues his brand of “value investing” is a lot cheaper than active management. (If you get 2% outperformance, his slightly higher expenses won’t matter.)

  But, that’s not all—fundamental indexing is less volatile than market-cap weighted indexing.

[Market-cap weighted index (MWI) is an index whose individual components are weighted according to their market capitalization.]

Remember, in MWIs, if a stock doubles in price, its weight in the index doubles too. Arnott asked a packed room of attendees:

 

Why should we do that? Cap-weighted indexes commit more of your money to an asset because it just got more expensive. They overweight the overpriced and underweight the underpriced.

He makes a good point. One of the slides from his presentation at the conference is below. You’ll see that using market cap alone to weight an index skews fundamental value…

Arnott’s concept isn’t new. He first presented it in a 2005 article in the Financial Analysts Journal titled “Fundamental Indexation.”

Since 2005, the “fundamentally weighted” FTSE RAFI U.S. 1000 Index has outperformed the “market-cap weighted” Russell 1000 Index by 1.33%.

You can read all about the concept in detail, for free, right here.

Bottom line: If you have fundamental indexing options available in your 401(k) plan, you should consider them. They don’t have to be core positions—they can serve as satellite positions (smaller weights) in your 401(k). They may earn you an extra 2% return. That may not sound like much… but it can amount to hundreds of thousands of dollars over the course of a 30-year career.

Now, if you’re strictly following the Palm Beach Research Group’s recommendations, you’re already enjoying a fundamental investment approach similar to Arnott’s. That’s because we’re constantly uncovering market inefficiencies and discovering legitimate valuations far beyond what market capitalization may suggest.

Our fundamental approach isn’t just number-crunching, though… we talk to companies, analyze their financial statements, read annual reports, look for catalysts, put an emphasis on safety, and more.