Focusing on Growth (Not Market Cap)

Indexes are weighted by their size, primarily market cap. Research Affiliates’ latest index focuses on Growth, rejiggering these indexes based on how fast companies are growing. At The Money', Barry speaks with Rob Arnott, founder of Research Affiliates (RAFI). Each week, “At the Money” discusses an important topic in money management. From portfolio construction to taxes and cutting down on fees, join Barry Ritholtz to learn the best ways to put your money to work. See omnystudio.com/listener https://omnystudio.com/listener for privacy information.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Speaker 00

  At Brookfield, we believe you can own wealth that's measured in generations. Because true ownership looks beyond today and beyond cycles. For 125 years, we've built long-term wealth through expertise, discipline, and a clear vision for the future. Providing investors access to alternative strategies built for what's next. Brookfield. Own what's next. Learn more at Brookfield.com/own. This is not an offer to sell or investment advice. Investing involves risks, including loss of capital. Past performance is not indicative nor a guarantee of future results. Please review performance and offering materials before investing.

• 0:38Speaker 01

  This is the Bloomberg Tech Minute brought to you by ChatGPT. I'm Carol Muster. Getting hired at SpaceX requires exceptional ability and may include having Elon Musk review a candidate's resume. So writes Bloomberg Businessweek's Lauren Grush. She reports that the company culture is defined by Musk and job candidates must understand that a commitment to SpaceX means adhering to this culture and exhibiting loyalty to Elon Musk. To get hired, candidates must demonstrate their achievements from past jobs and hands-on experience matters more to recruiters than advanced degrees, with the company looking for people with raw innate intelligence. A spokesperson for SpaceX didn't respond to a request for comment on its recruiting and hiring practices.

• 1:21Speaker 01

  But according to recruiters, advisors, and those who've interviewed for jobs there, it's the space exploration dream that draws people to the company and Musk invokes that dream regularly to remind workers why they're there. Prospective hires are told that the job will require stamina, including in job ads that candidates, quote, "must be willing to work extended hours and weekends as needed." One major perk for all that hard work? Employees' access to equity, either the right to buy shares or payment in the form of restricted stock units that vest over time. That's the Bloomberg Tech Minute brought to you by ChatGPT. Get started at ChatGPT.com.

• 2:18Barry Ritholtz?

  Traditional market cap weighted indexes like the S and P 500 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 Mag 7, higher valuations, and increased 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 Arnott, founder of Research Affiliates. The firm recently put out the

• 2:56Barry Ritholtz?

  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 investable, but I assume there'll be an ETF out sooner rather than later. Define Raffig. Define the Research Affiliates Growth Index. What are the weights based on? How do you think about alternatives to cap weighted growth?

• 3:29Speaker 03

  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, it's value, and if it's

• 4:13Speaker 03

  expensive, it's growth. No, if it's expensive, it's expensive.

• 4:19Speaker 03

  It's much simpler. If it's growth, it's growth. So to my astonishment, looking back, cap weighted indexing goes back to the 50s as investable portfolios to the 70s and growth indexes to the late 70s and growth, investable growth strategies to the 1980s. 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?

• 5:04Speaker 03

  And weights growth stocks based on how big their dollar contribution to the growth of the macro economy 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 30 years would have outperformed Russell Growth by 4.5% per annum going back almost 30 years.

• 5:31Barry Ritholtz?

  Russell Growth, not Russell Value.

• 5:33Speaker 03

  Correct.

• 5:34Barry Ritholtz?

  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 to the Raffi Growth Index.

• 5:52Speaker 03

  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 A J, take a look. For the moment, you can also find it on SSRN. Just look up R not fundamental growth and it'll take you right there. Anyway.

• 6:14Speaker 03

  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&D and it's a big enough part of their business that they break it out as a separate item in their P&L. So what about growth in P&L, excuse me, growth in R&D? Because if they're shrinking their R&D budget, that's a bad sign. And so if you have three different growth rates, growth in sales, growth in profits,

• 6:55Speaker 03

  and growth in R&D spending, if that's available, two of the three if it's not, 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 25%, let's use it. Here's a fun factoid: two of the magnificent seven don't make the cut for the Raffi Growth Index.

• 7:19Barry Ritholtz?

  Really, which two?

• 7:21Speaker 03

  Take a guess.

• 7:24Barry Ritholtz?

  So who's cutting way back on their R&D and not seeing increases in revenue? Apple and Amazon? I'm just spitballing.

• 7:40Speaker 03

  You got one out of two.

• 7:41Barry Ritholtz?

  So Apple is the first one?

• 7:42Speaker 03

  Amazon. Amazon and Microsoft both were growing incredibly fast in the 2010s and have been growing nicely in the 2020s, but not fast enough to make the cut. So they're left out of the Raffi Growth Index. The index is on Bloomberg, has been since last March, and it's already 13 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 investable ETF or mutual fund, not yet.

• 8:20Barry Ritholtz?

  When it comes out, when it becomes investable, 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?

• 8:47Speaker 03

  We select based on percentage growth. You could have a huge company that has sales grow by 100 billion in a year and it's only 10% growth, 5% 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 Raffi growth are 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.

• 9:30Speaker 03

  They are both a little over 10% of our index. Now, think what that means. If it's a 10% weight, that means that Nvidia has singularly, all by itself, been 10% of the sales or profit growth in the aggregate US economy.

• 9:49Barry Ritholtz?

  Wow. Huge.

• 9:51Speaker 03

  Apple has been 10% of the aggregate growth in sales or profits of the US economy. So by weighting companies 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 surge. You could have a tiny company that's grown 10-fold and if you weighted by that 10-fold growth, it's going to get a huge weight and it's a tiny company and it might be a flash in the pan.

• 10:21Barry Ritholtz?

  So in other words, the percentage gains matter, but so too do the real dollar gains.

• 10:26Speaker 03

  Exactly.

• 10:27Barry Ritholtz?

  I understand that. So curious about the volatility of this versus traditional cap weighting indexes. How does this compare? Are you getting better performance, but you have to live with a little more volatility?

• 10:41Speaker 03

  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 underperform. On average, over the last 28 years, it adds 4.5% a year, plus or minus 7%. So in just a normal disappointing year, it's gonna underperform by about 2. In a normal excellent year, it's gonna outperform by about 12. So since we launched in last March, the 13% outperformance means this is a very typical, very normal good year. And so you have to be willing to take a little bit of volatility.

• 11:25Speaker 03

  But if you go back, you find that it wins about 7 out of 10 years. That's pretty cool.

• 11:30Barry Ritholtz?

  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 aren't a whole lot of capacity or liquidity constraints? I'm assuming this can ramp up just like an S&P index or what have you?

• 11:51Speaker 03

  Short answer to your question is current AUM is zero, so there's loads of capacity. Longer answer is, an educated guess would be it could, it has about four times the turnover of the S&P, maybe five. So just on that alone, its capacity would be a fourth or a fifth out of the S&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 10 to 20% of the S&P. Given that there's about 15 trillion index to the S&P, that would be, that would give us something on the order of 1.5 to 3 trillion as a capacity.

• 12:33Barry Ritholtz?

  So, 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.

• 12:57Barry Ritholtz?

  Does the dominant narrative matter? Or is it just redefining its constituents based on what is best working today? What is seeing the highest increases in revenue profits and research and developments?

• 13:14Speaker 03

  Well, between Raffi, 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 weight them

• 13:55Speaker 03

  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 backtests of Raffi when we launched it 20 years ago showed about 2% value add relative to cap weighted value. It's added 2 to 2.5% live for 20 years. So you don't fall into the trap of creating a strategy that looks great in backtest and falls apart instantly.

• 14:25Barry Ritholtz?

  I'm so glad you said that because when do you ever see a bad backtest, right? All backtests are great.

• 14:32Speaker 03

  I see lots of bad backtests.

• 14:34Barry Ritholtz?

  Oh, no, I mean that gets...

• 14:35Speaker 03

  I would never promote it.

• 14:37Barry Ritholtz?

  The backtests that get shared are the ones that there's a little...

• 14:41Speaker 03

  Of course they are.

• 14:41Barry Ritholtz?

  Totally. And, and you know, inherent in every backtest 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, the backtests all fail. Many backtests that look great fail to, to perform in real life.

• 15:02Speaker 03

  That's exactly right.

• 15:03Barry Ritholtz?

  Because the world changes.

• 15:05Speaker 03

  And if you're doing a back test to create a better back test.

• 15:10Barry Ritholtz?

  Right, that's right.

• 15:12Speaker 03

  That's the epitome of data mining and it's endemic in our business.

• 15:18Barry Ritholtz?

  Absolutely. So, Rob, when this comes out as an investable product, be it an ETF or an SMA or a mutual fund, come back, tell us about it.

• 15:30Speaker 03

  I'm not sure it will because I'm trying to keep it secret because it's so good.

• 15:35Barry Ritholtz?

  Well, you and Jim Simons, 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 Affiliates Growth Index. It's not market cap weighted, it's not yet investable, 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 Ritholtz. You've been listening to Bloomberg's At the Money.

• 16:26Speaker 00

  At Brookfield, we believe you can own wealth that's measured in generations because true ownership looks beyond today and beyond cycles. For 125 years, we've built long-term wealth through expertise, discipline, and a clear vision for the future, providing investors access to alternative strategies built for what's next. Brookfield. Own what's next. Learn more at Brookfield.com/own. This is not an offer to sell or investment advice. Investing involves risks, including loss of capital. Past performance is not indicative nor a guarantee of future results. Please review performance and offering materials before investing.

• 17:04Speaker 01

  This is the Bloomberg Tech Minute brought to you by ChatGPT. I'm Carol Muster. Getting hired at SpaceX requires exceptional ability and may include having Elon Musk review a candidate's resume. So writes Bloomberg Business Week's Lauren Grush. She reports that the company culture is defined by Musk and job candidates must understand that a commitment to SpaceX means adhering to this culture and exhibiting loyalty to Elon Musk. To get hired, candidates must demonstrate their achievements from past jobs and hands-on experience matters more to recruiters than advanced degrees, with the company looking for people with raw innate intelligence. A spokesperson for SpaceX didn't respond to a request for comment on its recruiting

• 17:46Speaker 01

  and hiring practices, but according to recruiters, advisors, and those who've interviewed for jobs there, it's the space exploration dream that draws people to the company, and Musk invokes that dream regularly to remind workers why they're there. Prospective hires are told that the job will require stamina, including in job ads that candidates, quote, "must be willing to work extended hours and weekends as needed." One major perk for all that hard work? Employees' access to equity, either the right to buy shares or payment in the form of restricted stock units that vest over time. That's the Bloomberg Tech Minute brought to you by ChatGPT. Get started at ChatGPT.com.

• 18:27Speaker 04

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• 18:58Speaker 05

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• 19:29Speaker 06

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