Morningstar Advisor - Winter 2008 - 57

We are asked, ‘Aren’t you going to be disappointed if big caps rebound and outperform small caps?’ No. We’ll be pleased, because we now have a large-cap tilt. Rob Arnott KK: Is there a danger, as with other investing strategies, that when something becomes popular, the advantages begin disappearing? RA: This is an idea that has enormous power in terms of being scalable. We’ve penciled it out at $1 trillion. At $1 trillion—with the U.S. top 1,000—we would have 5% of the total market. We would have over 20% of the float of only 20 companies, most of them at the bottom of the list comprising less than 1% of the portfolio. So we’d have to start paying attention to float issues at somewhere around a $1 trillion AUM. This is a very scalable idea. It’s extremely low turnover. KK: Though not as low turnover as a typical index strategy. RA: Barely higher if you do it our way. Our way KK: You’ve been able to gather assets pretty RA: I think there’s a couple of ways to proceed, quickly, as well. RA: Oh, yeah. And what we will see is that as this idea gains traction, the fees will come down. Part of it’s a scale issue. If you’re running $100 million, it’s more expensive than if you’re running $100 billion as a percentage of assets. But which is the bargain? Something that costs 60 basis points and adds 200 to 300, or something that costs 10 basis points and adds zero? KK: Some critics have questioned the timing of when you launched these indexes, which was after value stocks had rebounded. Why didn’t you do it when the strategy would have added the most value, which was right around the time of the bubble as opposed to its aftermath? RA: I couldn’t control when the idea occurred to and the answer to that really varies depending on the customer. To me, Fundamental Index is a much more sensible core portfolio. It is neutral relative to the composition of the economy and contra trades against whatever are the most extreme bets, up or down, in cap weighting. I see it as a very elegant, powerful core portfolio. Those who say, “Well, relative to the market, it’s a value-tilted portfolio”—heck, in that context think of it as the best value alternative for the value side of your portfolio. It becomes even more powerful in international applications where you get country rebalancing. So I see this as an idea that naturally serves as a core. Should people put all of their core money in it? I would, but… KK: Do you? smoothes the financial measures of company size over time because there is volatility in sales and profits, and by doing that, the turnover’s 10%, against 6% for cap weighting. It’s a very slight difference. And either way, it’s drastically lower than the 100% that’s fairly typical in active management. So the idea is hugely scalable. If $1 trillion flowed into the idea, what would happen? Growth and value would be more similarly priced, the alpha of Fundamental Index from that point forward would be diminished, but the alpha during that transition would be increased, so that there is an early adopter advantage that’s tough to quantify, but it’s there. KK: One of the things that strikes me as I look at the market today is that some of the best values are large-cap companies. In my mind, that argues in favor of traditional indexes. RA: Think of it this way. Fundamental Index me. In fact, the trigger in large measure was the aftermath of the bubble. The catalyst that got me focused on this occurred two years after the bubble burst when it came to my attention that the average stock on the New York Stock Exchange was up over 20%. The indexes were down over 20%. You had this 4,000-basis-point gap between the performance of the indexes and of the average stock, so the indexes weren’t tracking the behavior of the average company. And that’s what got us started on this. The fact that Fundamental Index would have added more value had it been embraced at the peek of the bubble—well, it wouldn’t have been embraced at the peak of the bubble because the prior couple of years were the two worst years ever for Fundamental Index. KK: When you’re out in the marketplace now, how do you talk about using some of these strategies within a portfolio? RA: I have all of my core equity holdings, which are limited because I have a cautious view on equities, but all of my core equity holdings are in this because if I’m right this adds a ton of value in most down markets. If I’m wrong, it keeps pace in most up markets. What’s better than that? But what we find is that part of the issue of how to use Fundamental Index depends on who you are. Fundamental Index adds value seven out of 10 years historically. Suppose you’re an investment advisor, and you put all of your client’s core equity money into it at the start of one of those off years. Dangerous. So for most advisors, I think putting one fourth or one third of core equities into Fundamental Index is a wonderful first step to get clients comfortable and familiar with the idea. takes you from market weighting, with whatever biases and preferences are in the market, back to economic weighting. So you’re contra trading against wherever the market has its most extreme bets. Now, for large versus MorningstarAdvisor.com 57
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Morningstar Advisor - Winter 2008

Table of Contents for the Digital Edition of Morningstar Advisor - Winter 2008

Morningstar Advisor - Winter 2008
Contents
Letter from the Editor
Inbox
How Do You Use the Morningstar Style Box?
Real Estate Investing Goes Global
The Golden Touch
Investment Briefs
Learning to Fly with Equity Options
Another Block in Building a Portfolio
In a League of Their Own
Unlock the Box
Fashion Change
The View from the Investment Side
Unpredictable Style
Weighting the Fundamentals
Wire-to-Wire Consistency
The Secret's Out
Focus on Financials
Strongest Homebuilders Will Withstand the Wrecking Ball
Breaking Style Conventions
Playing It Safe with Financials
Back to Bond School
Mutual Fund Analyst Picks
Undervalued Stocks
Most Popular Variable Annuities
New at Morningstar
The Style Counsel
Morningstar Advisor - Winter 2008 - Intro
Morningstar Advisor - Winter 2008 - Morningstar Advisor - Winter 2008
Morningstar Advisor - Winter 2008 - Cover2
Morningstar Advisor - Winter 2008 - 1
Morningstar Advisor - Winter 2008 - 2
Morningstar Advisor - Winter 2008 - Contents
Morningstar Advisor - Winter 2008 - 4
Morningstar Advisor - Winter 2008 - 5
Morningstar Advisor - Winter 2008 - 6
Morningstar Advisor - Winter 2008 - Letter from the Editor
Morningstar Advisor - Winter 2008 - 8
Morningstar Advisor - Winter 2008 - Inbox
Morningstar Advisor - Winter 2008 - How Do You Use the Morningstar Style Box?
Morningstar Advisor - Winter 2008 - 11
Morningstar Advisor - Winter 2008 - Real Estate Investing Goes Global
Morningstar Advisor - Winter 2008 - 13
Morningstar Advisor - Winter 2008 - 14
Morningstar Advisor - Winter 2008 - The Golden Touch
Morningstar Advisor - Winter 2008 - 16
Morningstar Advisor - Winter 2008 - 17
Morningstar Advisor - Winter 2008 - Investment Briefs
Morningstar Advisor - Winter 2008 - 19
Morningstar Advisor - Winter 2008 - 20
Morningstar Advisor - Winter 2008 - 21
Morningstar Advisor - Winter 2008 - Learning to Fly with Equity Options
Morningstar Advisor - Winter 2008 - 23
Morningstar Advisor - Winter 2008 - 24
Morningstar Advisor - Winter 2008 - 25
Morningstar Advisor - Winter 2008 - Another Block in Building a Portfolio
Morningstar Advisor - Winter 2008 - 27
Morningstar Advisor - Winter 2008 - 28
Morningstar Advisor - Winter 2008 - 29
Morningstar Advisor - Winter 2008 - In a League of Their Own
Morningstar Advisor - Winter 2008 - 31
Morningstar Advisor - Winter 2008 - 32
Morningstar Advisor - Winter 2008 - 33
Morningstar Advisor - Winter 2008 - 34
Morningstar Advisor - Winter 2008 - 35
Morningstar Advisor - Winter 2008 - Unlock the Box
Morningstar Advisor - Winter 2008 - 37
Morningstar Advisor - Winter 2008 - 38
Morningstar Advisor - Winter 2008 - 39
Morningstar Advisor - Winter 2008 - Fashion Change
Morningstar Advisor - Winter 2008 - 41
Morningstar Advisor - Winter 2008 - 42
Morningstar Advisor - Winter 2008 - 43
Morningstar Advisor - Winter 2008 - The View from the Investment Side
Morningstar Advisor - Winter 2008 - 45
Morningstar Advisor - Winter 2008 - 46
Morningstar Advisor - Winter 2008 - 47
Morningstar Advisor - Winter 2008 - 48
Morningstar Advisor - Winter 2008 - 49
Morningstar Advisor - Winter 2008 - 50
Morningstar Advisor - Winter 2008 - 51
Morningstar Advisor - Winter 2008 - Unpredictable Style
Morningstar Advisor - Winter 2008 - 53
Morningstar Advisor - Winter 2008 - Weighting the Fundamentals
Morningstar Advisor - Winter 2008 - 55
Morningstar Advisor - Winter 2008 - 56
Morningstar Advisor - Winter 2008 - 57
Morningstar Advisor - Winter 2008 - 58
Morningstar Advisor - Winter 2008 - 59
Morningstar Advisor - Winter 2008 - 60
Morningstar Advisor - Winter 2008 - 61
Morningstar Advisor - Winter 2008 - Wire-to-Wire Consistency
Morningstar Advisor - Winter 2008 - 63
Morningstar Advisor - Winter 2008 - 64
Morningstar Advisor - Winter 2008 - 65
Morningstar Advisor - Winter 2008 - The Secret's Out
Morningstar Advisor - Winter 2008 - 67
Morningstar Advisor - Winter 2008 - 68
Morningstar Advisor - Winter 2008 - 69
Morningstar Advisor - Winter 2008 - Focus on Financials
Morningstar Advisor - Winter 2008 - 71
Morningstar Advisor - Winter 2008 - 72
Morningstar Advisor - Winter 2008 - 73
Morningstar Advisor - Winter 2008 - Strongest Homebuilders Will Withstand the Wrecking Ball
Morningstar Advisor - Winter 2008 - 75
Morningstar Advisor - Winter 2008 - Breaking Style Conventions
Morningstar Advisor - Winter 2008 - 77
Morningstar Advisor - Winter 2008 - Playing It Safe with Financials
Morningstar Advisor - Winter 2008 - 79
Morningstar Advisor - Winter 2008 - 80
Morningstar Advisor - Winter 2008 - Back to Bond School
Morningstar Advisor - Winter 2008 - 82
Morningstar Advisor - Winter 2008 - Mutual Fund Analyst Picks
Morningstar Advisor - Winter 2008 - 84
Morningstar Advisor - Winter 2008 - 85
Morningstar Advisor - Winter 2008 - 86
Morningstar Advisor - Winter 2008 - 87
Morningstar Advisor - Winter 2008 - Undervalued Stocks
Morningstar Advisor - Winter 2008 - 89
Morningstar Advisor - Winter 2008 - 90
Morningstar Advisor - Winter 2008 - 91
Morningstar Advisor - Winter 2008 - Most Popular Variable Annuities
Morningstar Advisor - Winter 2008 - 93
Morningstar Advisor - Winter 2008 - New at Morningstar
Morningstar Advisor - Winter 2008 - 95
Morningstar Advisor - Winter 2008 - The Style Counsel
Morningstar Advisor - Winter 2008 - Cover3
Morningstar Advisor - Winter 2008 - Cover4
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