Rob Arnott, the pot calls the kettle black

He’s at it again. CNN Money reports Robert Arnott — the reason to know this name will become clear in a minute — is annoyed that hedge funds continue to charge big bucks for poor performance:

Hedge funds have traditionally been investment vehicles for the rich and universities. But in the past decade or so, they have drawn more and more money from public pensions and other accounts that hold the retirement funds of the middle class. Assets in hedge funds have more than tripled in the past decade to $2.25 trillion, according to Research Affiliates.
“The results have been a disappointment, and yet asset flows continue at an astronomical rate,” says Arnott.
Part of that has to do with the sales pitch.

Stop right there. Is Rob giving a counter-pitch because HE wants some of that $2.25 trillion? Because managing $100 billion is not enough?
rob-arnottHow much more does he want for the magic indexing formula that has made him rich?
Arnott is such a good salesman that he gathered all these assets with a single paper published in 2005. Based on backtesting, his conclusion was, “We believe these results are not mere accidents of history but are likely to persist into the future.”
It’s 2013 now, and time to see how things turned out for the investors.

Fund Faceoff

Suppose we invested in Rob’s flagship vehicle for fundamental indexation, the PowerShares FTSE RAFI US 1000 Portfolio (PRF). Are we getting good bang for the buck?
First, strip out dividends. There is no need to pay someone to collect dividends for us. We also don’t want to reward a fund manager for skill if all he did was buy dividend-paying stocks and junk bonds. We level the dividend playing field. Use price-only data that we can get anywhere.
The worst month was -18%. The worst 12-month rolling loss was -48.65%, exceeding the -30 yardstick test.
Second, calculate standard deviation. This is a fundamental, yet useful statistic for our purposes because every sales pitch is based on “we are better than the other guy” or “we are better than the benchmark index”. The WealthCop Investor knows about the myth of beating the market, and won’t fall for that trick again.
The standard deviation metric is independent of the underlying strategy, amount of leverage or benchmarks. It is its own benchmark, of how big of a roller coaster, because a wild ride deprives us of steady compounding. Consistency is king.
We generally use the 3-year standard deviation, but you can use a longer period if you like. Compared to the S&P 500 Index (without dividends), PRF is more volatile.
Third, calculate bang for the buck. We always take income AND expense into account to calculate earnings. In baseball, we look at hits divided by at bats. Yet somehow, most investors think about “performance” in terms of reward, NEVER ABOUT RISK.
The WealthCop Investor divides the return by the risk to arrive at the Reward for Risk ratio. It goes without saying that a fund or a strategy which features more risk than reward is not for us, no matter how well it does in any given year.
We generally divide the 3-year return by the 3-year standard deviation, but you can use a longer period if you like. By this measure, the S&P 500 Index produced 1.5836 units of reward per unit of risk while PRF delivered 1.4964 units of reward per unit of risk.
Considering the gross expense ratio for the PowerShares FTSE RAFI US 1000 Portfolio (0.43%, and rises to 1.22% on September 1, 2013) is 400% more than the SPDR® S&P 500® ETF (0.1102%), which fund would you choose?