The World According to 'The Bear'

(page 2 of 2)

Browse Issues

Browse the BusinessWeek Archive

Arnott puts his stamp on the controversial approach in a new book

Story Tools

• post a comment
• e-mail this story
• print this story
• order a reprint
• suggest a story
• digg this
• save to del.icio.us

But the unofficial reason for the change of location is that Arnott fell in love with the beach when he was studying economics, applied mathematics, and computer science as a student at University of California at Santa Barbara in the 1970s.

Now he and his wife, Marina, are living in a beachfront property—but he rents it. His skepticism about equities, it turns out, is paired with a weak forecast for real estate. His says it makes more sense to rent a $5 million house for $8,000 a month than to be saddled with a huge mortgage and high property taxes: "That's the situation in coastal [Orange County]."

His big-picture view on real estate is that plunging home prices will continue to fuel a consumer-spending slump. That's because the cash consumers tapped from home-equity loans amounted to 5% of gross domestic product, he says. Arnott figures that roughly half of the $600 billion in home-equity withdrawals was used to buy consumer goods in 2005.

From his new stomping grounds, Arnott continues to beat the drum for a subject he's passionate about: fundamental indexing. It's a way of weighting indexes on metrics such as sales, cash flow, and dividends rather than by market capitalization. Although several people claim to be pioneers in this area, Arnott puts his stamp on the theory in a new book, The Fundamental Index: A Better Way to Invest (Wiley; $29.95), which he co-authored with colleagues. "If I didn't write it," he says, "someone else would."

Arnott says there is a basic problem with traditional indexing: Companies are weighted by market capitalization, which leads to an overweighting of overvalued companies and an underweighting of undervalued ones. Fundamental indexers say focusing on metrics such as sales makes it easier to identify the most undervalued companies. "The idea behind the traditional index fund is a very powerful one," says investor and author Peter Bernstein, an adviser to Arnott. "To take issue with it in this way takes Rob Arnott's tenacity and thinking."

Indeed, Arnott's tweaking of the tenets of passive investing raises the ire of indexing stalwarts such as Vanguard Group founder Jack Bogle, whom Arnott considers an investment hero. "My problem is that the basic thesis of fundamental indexing is definitely not proven," says Bogle, who's skeptical of backtesting data that show such indexes outperforming the Standard & Poor's 500-stock index by two percentage points annually for the past 46 years.

Bogle also notes that the PowerShares FTSE RAFI U.S. 1000 ETF, which uses Arnott's strategy and tracks the performance of the largest U.S. equities based on book value, cash flow, sales, and dividends, is down 13.4% for the past 12 months, while the Vanguard 500 Index Fund is down 7.93%. "He's gone down almost twice as much as the market in the last 12 months. That's pretty remarkable," says Bogle. "It's especially remarkable since he assured the world that his theory also gave better downside protection."

"Of course it has underperformed," Arnott counters. The cap-weighted index tilts toward growth companies, while fundamental indexes favor value companies, he explains.

The controversy doesn't end there. Among fundamental indexers, there's squabbling over who gets credit for the idea as well as the optimal way to construct a fundamental index. Arnott says he stays out of the fray to focus on getting more institutions to buy his index products. Just $30 billion of $5 trillion in indexed assets is in fundamental indexing strategies.

Arnott takes a measured approach to his hobbies, too. In January he set a goal of riding at least two of his 20 vintage motorcycles every month. (He's a little behind on his goal.) Some of his prized bikes include a Morbidelli built by Enzo Ferrari's engineering team and a 1949 Vincent Black Lightning that set an Australian Land Speed Record of 154 mph in 1949. His worst fear: that fellow cycle enthusiast and talk show host Jay Leno will find out about a bike he's interested in and outbid him.

Arnott also travels the globe chasing solar eclipses. "A total solar eclipse is the most remarkable—and beautiful—spectacle that the skies can offer us," he says. His goal is to spend an hour of his life under eclipses—no easy feat considering some last for 30 seconds. So far he has viewed nine, including one from Eastern Antarctica. He expects to cross the half-hour mark on Aug. 1, in Central China.

Bear markets, like eclipses, can be fleeting, but Arnott foresees a down market with staying power. "We've only seen the first leg," he says.