Bloomberg has a great article on intelligent indexing, specifically on Rob Arnott’s RAFI Index and how well it has done since inception. Witchcraft enters the conversation only because of a comment by John Bogle:
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 Inc. (MORN) 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 RAFI index intelligently tries to exploit the value return factor, given that its fundamental weighting scheme has a value tilt. This makes perfect sense to me. When a known return factor is available, why not exploit it, especially when it can be done rather efficiently and for relatively low cost in an ETF format?
The Technical Leaders Index (PDP), also sponsored by PowerShares, attempts to exploit the relative strength return factor in exactly the same fashion. In fact, over the time period that both indexes have existed in common, since March 1, 2007, both the RAFI 1000 (PRF) and the Technical Leaders Index (PDP) have had comparable price returns, +3.97% for PRF and +7.63% for PDP. They are exploiting completely different factors, which may be dominant at very different times, but both have outperformed Vanguard’s S&P 500 fund over that stretch.
There’s certainly no guarantee what will happen over a longer time period—maybe cap weighting is due for a comeback. But trying intelligently to exploit return factors that are omnipresent in the data makes perfect sense. It will be a good sign for intelligent indexing if Jack Bogle is eating Rob Arnott’s dust for many years to come.
Click to enlarge. Source: stockcharts.com
Posted by Mike Moody 
