Rob Arnott isn’t afraid to go against the grain.  His “fundamental indexing” methodology ignores price and value-weighted indices and instead uses fundamental business metrics such as sales and revenue to construct investment benchmarks.  He says this avoids the propensity for indices to overweight temporarily overvalued stocks and underweight temporarily undervalued stocks.

But the idea has always had its skeptics – many of whom argue that fundamental indexing amounts to value investing in disguise.  After all, they say, it simply amounts to overweighting high book-to-price stocks and underweighting low book-to-price stocks.  Arnott is well aware of such criticisms and apparently plans to launch a counter-offensive soon.  According to P&I, that counter-offensive will involve none other than Harry Max Markowitz, father of modern portfolio theory.

P&I reports on a paper in the works by Harvard professor Andre Perold called “Fundamentally Flawed Indexing”.  Apparently, those who have seen it say it makes a lot of sense.  Eric Sorensen, president and CEO of PanAgora (see posting: “King of Quants“) tells P&I that fundamental indexation assumes “large-cap stocks are overvalued, and you don’t know that”.

However, Arnott is unfazed and tells P&I that Perold’s criticism is ”a little frustrating: in my view, he puts words into my mouth, and then disproves what he says I say.

Like AllAboutAlpha.com (”Arnott: Does my beta produce alpha?”), Perold suggests that Arnott’s beta might actually be alpha and that it should be judged as such.  Says P&I:

“If fundamental indexing proponents such as Mr. Arnott would say they ‘truly know something about market cap that is not reflected in current prices’ and can improve on cap-weighted index returns, that would be a different story, said Mr. Perold. ‘Of course, you are then in the realm of active management, and you should be held accountable to the same standards as everyone,’ such as being judged by one’s live track record, he said.”

Analytic Investors’ Harindra de Silva (see related posting: “Fundamentalism in Active Management“) plays the reconciling middle child in this family spat.  P&I says that de Silva believes “…fundamental indexing could remain in demand. Even if it’s finally seen as a particular implementation of a value-oriented strategy, the fact that it’s well-constructed, transparent and a low-fee way of capturing the market’s value premium will attract investors.”

Sounds a lot like the rancorous debate currently happening in the ETF world as that industry tries to figure out if “active ETF” is an oxymoron.

- Alpha Male

Editor’s Note: For more information on Arnott, Sorensen, de Silva and Markowitz, check out AllAboutAlpha’s new Who’s Who section.

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