Beyond Market Cap: Fundamental Indexing Explained (With Rob Arnott)

Jan 31, 2025

Rob Arnott, founder of Research Affiliates, is a trailblazer in fundamental indexing, challenging traditional investment norms. He explains how fundamental indexing selects companies based on real economic size rather than market cap, leading to potentially better returns. Arnott highlights the pitfalls of forecasting market trends and critiques established financial theories like the efficient market hypothesis. The discussion also touches on the emotional factors that drive investor behavior, offering fresh perspectives on market dynamics.

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INSIGHT

RAFI vs. Traditional Indexing

RAFI, the Research Affiliates Fundamental Index, weights companies based on business size, not market cap.
This offers a value tilt by overweighting out-of-favor companies and downweighting popular growth stocks.

INSIGHT

Forecasting Stock Returns

Forecasting next year's stock returns is unreliable, while long-term forecasts (over a decade) are more feasible.
Long-term returns depend on yield, growth, and changes in valuation multiples, which are easier to estimate over longer periods.

ANECDOTE

20th Century Stock Returns

In the latter half of the 20th century, stocks yielded 8% initially, but ended with a 1.1% yield during the dot-com bubble.
Half of the 8% risk premium during this time came from increased valuations, which shouldn't be relied upon for future returns.

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In this episode, Liz Ann Sonders and Kathy Jones discuss this week’s FOMC meeting and the market reactions.

Then, Liz Ann speaks with Rob Arnott, founder and chairman of the board of Research Affiliates®. They discuss some of the advanced approaches of Research Affiliates, particularly focusing on the Research Affiliates Fundamental Index® (RAFI) and its implications for growth and value investing. They explore the differences between traditional indexing methods and RAFI, the challenges of forecasting market returns, and the potential for paradigm shifts in finance. The discussion emphasizes the importance of understanding market dynamics and the nuanced definitions of growth and value in investment strategies.

Finally, Kathy and Liz Ann look ahead to the data and economic indicators that investors should be watching next week.

You can read Rob’s article, which Liz Ann mentions, here: "Fifty Years of Innovation, Mythmaking, and Mythbusting: Personal Reflections."

On Investing is an original podcast from Charles Schwab. For more on the show, visit schwab.com/OnInvesting.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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Investing involves risk, including loss of principal.

Performance may be affected by risks associated with non-diversification, including investments in specific countries or sectors. Additional risks may also include, but are not limited to, investments in foreign securities, especially emerging markets, real estate investment trusts (REITs), fixed income, municipal securities including state specific municipal securities, small capitalization securities and commodities. Each individual investor should consider these risks carefully before investing in a particular security or strategy.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

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The trade names "Research Affiliates®" and "Fundamental Index®" are registered trademarks of Research Affiliates, LLC.

Fundamental Index® is a trademark of Research Affiliates. Rob Arnott, Research Affiliates, and FTSE Russell are unaffiliated with Schwab Asset Management® and Charles Schwab & Co.

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