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The Fundamental Index: A Better Way to Invest


Praise for the fundamental index

"The Fundamental Index® method is a controversial financial innovation in the field of passive investing, but this book confronts the whole range of controversy head on. The case for use of the Fundamental Index method and against cap-weighted indexes is uncommonly lucid, well illustrated, and attention-grabbing. You cannot reach a judgment on the Fundamental Index strategy, pro or con, without reading The Fundamental Index."
—Peter L. Bernstein, author of Capital Ideas Evolving

"The Fundamental Index method is a financial innovation so logical that it is compelling to any and all who believe that common sense is a required ingredient for portfolio construction."
—Bill Gross, Chief Investment Officer and founder of PIMCO

"Rob Arnott's idea is both elegant and profound, yet some very smart people have trouble grasping his idea because of their unexamined assumptions about how the market works. This book will help the reader get past those assumptions."
—Jack Treynor, President of Treynor Capital Management, Inc.

"Rob Arnott is a financial pioneer and this volume is a welcome addition to the rapidly evolving debate surrounding the true nature of indexation and passive investing."
—Andrew W. Lo, Harris & Harris Group Professor, Director, MIT Laboratory for Financial Engineering, MIT Sloan School of Management

"Rob's research on the Fundamental Index approach was a major epiphany for me. He has turned conventional investing wisdom on its head. This idea is a BIG deal—it will be the fastest new investment idea to reach $100 billion in assets in history. Every investor needs to read this book."
—John Mauldin, Millennium Wave Investments, author of Bull's Eye Investing and Just One Thing

Robert D. Arnott is a leading industry thinker and researcher who served as the editor of the Financial Analysts Journal from 2002–2006 and who has authored over 100 articles for journals such as the Financial Analysts Journal, the Journal of Portfolio Management, and the Harvard Business Review. Arnott serves as Chairman of Research Affiliates, LLC, a global leader in innovative investing and asset allocation strategies. Founded in 2002, Research Affiliates distributes investment products in partnerships with leading financial institutions including PIMCO, PowerShares, Charles Schwab, Nomura Asset Management, and FTSE, to name only a few.

Jason C. Hsu, PhD, is Managing Director, respon-sible for Research and Investment Management, at Research Affiliates, LLC. He is also a Professor in Finance at the Anderson School of Business at UCLA.

John M. West is Associate Director and Product Specialist at Research Affiliates, LLC. Previously, he was vice president and senior consultant at Wurts & Associates, where he managed the firm's overall research effort.



Chapter 1. Efficient Indexing for an Inefficient Market.

Evidence of Market Efficiency.

The Case for Indexing.

Evidence of Market Inefficiency.


Chapter 2. Origins of the Fundamental Index Concept.

The Origins of Research Affiliates Fundamental Index (RAFI).

A Series of Aha! Moments

Research Affiliates Fundamental Index.

Fundamental Index Performance.

Concluding Thoughts: A Better Way to Invest.

Chapter 3. Investors Greatest Errors.

Negative Alpha.

Practicing What We Preach.


Chapter 4. The Virtues of Index Funds.

The Appeal of Equity Investing.

Equity Investing Choices.

The One Guarantee in Investments—Costs Matter.

Index Fund Advantages.

Avoiding the Performance Game.

Concluding Point.

Chapter 5. The Index Fund's Achilles Heel.

Market Efficiency: Two Interpretations.

Constructing a Well-Functioning Index.

The Achilles Heel of Cap-Weighting.

The Problems with Equal Weighting.

Concluding Thoughts.

Chapter 6. A Fundamental(ly) Better Index.

Building the Fundamental Index.

Adjustments for non-dividend-paying companies.

Why Multiple Measures of Company Size?

Advantages of a Composite Measure.

An Index of the Broad Economy.

Capacity and Liquidity.

Reconstituting the Fundamental Index: Keeping Turnover Low.

Concluding Comments.

Chapter 7. Fundamental Index Performance in U.S. Stocks.

RAFI US Large Company Performance.

Digging Deeper across Market Cycles.

Digging Deeper into Different Time Periods.

An Equal Comparison: Fundamental Index vs. Equal Weighting.

Out-of-Sample Results: Small Companies.

Using the Fundamental Index with Style: Growth and Value Applications.

Narrowing the Focus: NASDAQ.

Narrowing the Focus: REITs.

Narrowing the Focus: Sector Performance.

Extending the Analysis Back in Time.


Chapter 8. Beyond Borders: Fundamental Index Performance in Global Markets.

Fundamental Index Performance in Global Markets.

Multicountry Portfolios.

Emerging Markets.

Consistency Counts.

Concluding Comments: Lessons Learned From the Global Markets.

Chapter 9. Has Theory Led the Profession Astray?

Will the Real Active Strategy Please Step Forward?

The Origins of Cap Weighting.

Apparent Validation of Cap Weighting by Theory.

Forty Years Later: Empirical Results of the CAPM.

Ockham's Razor Applied.

Concluding Comments: Theory and the Profession.

Chapter10. The Basic Criticism: Our Style and Size Tilt.

Merely a Value Tilt.

Small-Cap Bias.

Fama and French Factors.

Some Big Surprises in Small Companies.


Chapter 11. Other Common Critiques: Hits and Misses.

Mining the Data?


Is It an Index?

Do We Know Which Stocks Are Overvalued?

How Long Can It Last?


Chapter 12. Why Trust the Fundamental Index Concept?

Stock Logic.

The Present vs. the Future: How Often Is Wall Street Right?

Why Does Wall Street Get It Wrong?

Dynamic Style and Size Exposures: When Do We Want Value and Small Cap?

Show Me the Numbers.

Fundamental Index Strategy vs. the Crystal Ball.

Does the Fundamental Index Concept work in Bonds?


Chapter 13. The Future for the Fundamental Index: Secular Market Considerations.

What Can We (Rationally) Expect from Our Investments?

Forecasting Bond Returns.

Forecasting Stock Returns.

The Fundamental Index Strategy in a Low-Return Environment.

The Outlook for Pricing Errors.

Could Pricing Errors Actually Increase?


Chapter 14. Using the Fundamental Index.

Asset Allocation and the Fundamental Index Strategy.

Should We Change Our Benchmark?

Diversifying the Passive Allocation.

Different Markets, Different Investors, Different Needs.