The load up man, and you put the load and run the loan right on.
Traditional market cap weighted indexes like the S and P five hundred have really done a great job in dominating investor inflows. But today there's concerns of cap weighting that is leading into increased market concentration into just a handful of stocks, especially the MAC seven, higher valuations, and increase risks for investors. How should an index investor think about this? Well, to help us unpack all of it and what it means for your portfolio, let's bring in Rob or Not,
founder of Research Affiliates. The firm recently put out the Research Affiliates Growth Index that's different from both cap weighted ETFs, but also different from equal weight ETFs. So I'm fascinated by this index which you guys put out. You're tracking it live today. It's not yet investible, but I assume there'll be an ETF out sooner rather than later. Define graphic, Define the research affiliate's growth index, What are the weights
based on? How do you think about alternatives to cap weighted growth.
Let's back up just a little bit and challenge one of the basic principles of modern investing and modern finance, the principle that there's this binary duality of growth and value. If it's not value, it's growth. If it's not growth, it's value. Pardon me, Those are not one dimension. Those are two dimensions. You can have cheap and expensive, you can have fast and slow growing, two different, completely different dimensions.
Our industry has had a fixation on this simple duality where if it's cheap, its value, and if it's expensive its growth. No, if it's expensive, it's expensive, it's much simpler. If it's growth, it's growth. So, to my astonishment, looking back, cap weighted indexing goes back to the fifties, as investible portfolios to the seventies, and growth indexes to the late seventies,
and growth investible growth strategies to the nineteen eighties. Nobody has posed the question, why don't we look at this fundamentally instead of based on valuations. Nobody has asked the question, why don't we create an index that chooses growth stocks based on how fast they're growing, and weight's growth stocks based on how big their dollar contribution to the growth of the macroeconomy is. If you do that, if you choose companies that are growing rapidly, and you weight them
on the dollar magnitude of that growth. You wind up with an index that, over the last thirty years would have outperformed Russell growth by four and a half percent peranum going back almost thirty years.
Russell growth not Russell value.
So correct.
So if that's the case, what are we selecting on It's not just cap weight. I'm assuming it's and I've read some of the research. You're looking at increasing sales, increasing profits, increasing R and D explain what goes in growth?
Well, there's an article coming out in the next issue of the Financial Analyst Journal that takes a deep dive. So anyone who's got access to the f AJ take a look for the moment. You can also find it on SSRN. Just look up are Not Fundamental Growth and it'll take you right there. Anyway, if you wanted a growth index that didn't anchor on expensive stocks but anchored on fast growing companies, how would you instinctively choose to
measure that? Growth? Sales, profits? Those are the obvious choices, slightly less obvious. Most growth companies have R and D and it's a big enough part of their business that they break it out as a separate item in their P and L. So what about growth in P and L? Excuse me, growth in R and D because if they're shrinking their R and D budget, that's a bad sign.
And so if you have three different growth rates, growth in sales, growth in profits, and growth in R and D spending, if that's available two of the three, if it's no, you average those growth rates, and you've got a very good gauge of how fast the company's growing. If it's growing rapidly enough to be in the top twenty five percent, let's use it. Here's a fun factoid. Two of the Magnificent seven don't make the cut for the Raffi Growth Index.
H really, which two?
Take a guess?
So who's cutting way back on their R and D and not seeing increases in revenue? Apple and Amazon. I'm just spitballing.
You got one out of two.
So Apple is the first.
Amazon, Amazon and Microsoft both were growing incredibly fast into the twenty tens and have been growing nicely in the twenty twenties, but not fast enough to make the cut, so they're left out of the Raffie Growth Index. The index is on Bloomberg has been since last March, and it's already thirteen percentage points in less than a year ahead of Russell growth. So the idea works and it's exciting. I wish I was on your show to announce that it's an investible ETF for mutual fund. Not yet.
When it comes out, when it becomes investible, we'll have you back. I want to ask you a question about dollar magnitude as opposed to percentage magnitude of growth. This is something that every metric I see is almost always a percentage. You're looking at absolute dollars of growth. Explain the thinking behind this. How does it manifest in performance?
How does it work? We select based on percentage growth. You could have a huge company that has sales grow by one hundred billion in a year and it's only ten percent growth five percent growth, and if that's the case, it's not a particularly growth company. So percentage growth is used to choose the companies. Now, the two biggest stocks in Raffie growth are in Nvidia and Apple. One has had stupendous growth from a low base. One has had good growth from a high base. Both have had percentage
growth fast enough to make the cut. They are both a little over ten percent of our index. Now, think what that means. If it's a ten percent weight, that means that Nvidia has singularly, all by itself been ten percent of these sales or profit growth in the aggregate US economy. Wow, huge Apple has been ten percent of the aggregate growth in sales or profits of the US economy. So by weighting company in proportion to the dollar magnitude, you're not going to introduce a bias towards frothy, tiny
companies that have had just a big percentage search. You could have a tiny company that's grown tenfold, and if you wait it by that tenfold growth, it's going to get a huge weight and it's a tiny company and it might be a flash in the pan.
So, in other words, the percentage gains matter, but so too do the real dollar gains. Exactly right, I understand that. So curious about the volatility of this versus traditional capwaiting indexes. How does this compare? Are you getting better performance but you have to live with a little more volatility.
The short answer is you have to live with a little bit more volatility, and you have to live with occasional periods when it will underperformed on average over the last twenty eight years, it adds four and a half percent a year, plus or minus seven percent. So in just a normal disappointing year, it's going to underperform by about two In a normal excellent year, it's going to
outperform by about twelve. So since we launched in last March, the thirteen percent out performance means this is a very typical, very normal good year, and so you have to be willing to take a little bit of volatility. But if you go back, you find that it wins about seven out of ten years. Wow, that's pretty cool.
Yeah, to say the very least. So, since we're talking about a lot of not just large cap companies, but companies with a substantial economic footprint, my assumption is there are a whole lot of capacity or liquiditly constraints. I'm assuming this can ramp up just like an S ANDP index or what have you.
Short answer your question is current AUM is zero, so there's loads of capacity. Longer answer is a educated guess would be it could. It has about four times the turnover of the S and P maybe five, So just on that alone, its capacity would be a fourth or a fifth out of the S and P. It's also tilted towards a particular category, not the whole broad market,
so that would suggest another haircut. I think its capacity would be ten to twenty percent of the S and P. Given that there's about fifteen trillion index to the S and P that would be that would give us something on the order of one and a half to three trillion as a capacity.
So plenty of capacity. Last question, I've been watching various narratives come into favor and then fade. We went through a whole blockchain crypto set of narratives. AI seems to be in the midst of its various narratives.
When you think.
About the Research Affiliates Growth Index Fundamental Growth Index, does the dominant narrative matter or is it us redefining its constituents based on what is best working today, what is seeing the highest increases in revenue, profits and research and developments.
Mended well between RAFI, the fundamental index, which has stark value tilt, and RAFFI growth, which has a stark growth tilt. I like to think that we're launching a revolution in indexing. I mean, the runway for this is huge. One other observation we're quantitative investors. We love testing things. Quantitative investors are addicted to data mining. Go back historically and ask what can I construct that's worked. We don't do that. Scientific method means you start with a hypothesis and you
only use the data to test the hypothesis. Our hypothesis was if you select companies on how fast they're growing and wait them on how large the magnitude of their contribution to the economic growth. This is an idea that might work pretty darn well. And lo and behold it does. The back tests of RAFFI when we launched it twenty years ago showed about two percent value add relative to cap weighted value. It's added two to two and a
half percent live for twenty years. So you don't fall into the trap of creating a strategy that looks great in back test and falls apart instantly.
I'm so glad you said that, because when do you ever see a bad back test?
Right?
All back tests are great?
That I see lots of bad vatus. Oh no, I mean that gain never promoted.
The back tests that get shared are the ones that there's.
A little worse.
There are totally and and you know inherent in every back test is the concept that the future is going to look like the past, and very often we see the future does not look like the past. So the back tests all fail. Many back tests that look great fail to perform in real life. The world changes.
And if you're doing a back test to create a better.
Back test, right, that's right, that's.
That's the epitome of data mining, and it's endemic in our business, absolutely so.
Rob when the when this comes out as an investible product, be it an ETF or an SMA or a mutual fund, come back tell us about it.
I'm sure it will because I'm trying to keep it secret because it's so good.
Well, you and Jim Simon's like, kick out all the outside investors and just keep your own money into it works well. So to wrap up, if you're concerned about cap weight, if you're concerned about market concentration or valuation, take a look at the research affiliate's growth index. It's not market cap weighted, it's not yet investible. But I know research affiliates, and I'm pretty confident there will be an ETF for you to put money into at some
point in the future. I'm Barry results you've been listening to Bloomberg's At the Money, you put the load right alone, right on