In the 4th century BC, Aristotle proposed that the known universe revolved around Earth.
We now see the absurdity of that idea, of course, yet it sounded logical enough to hold sway for about 1,800 years, until Copernicus suggested a then-outrageous alternative.
Robert Arnott, a Pasadena-based money manager, thinks the modern investment business can learn something from Copernicus' heresy: The industry, he says, should be less afraid to question conventional wisdom -- particularly when it's deeply entrenched.
Arnott is a well-known name in investment circles who heads a firm called Research Affiliates. Since 2002 he also has served as editor of the Financial Analysts Journal, a forum for Wall Street pros, academics and others with a serious interest in finance.
A statistics whiz with a passion for vintage motorcycles, Arnott has used his journal editorials to poke at many classic investment dogmas, question their application in the real world and effectively challenge his peers to wonder whether there are better ways to construct clients' portfolios.
Lately, he has been focused on a portfolio of immense proportions: the estimated $1.7 trillion that U.S. investors have in index stock funds, most of which seek to replicate the performance of the blue-chip Standard & Poor's 500 index.
The vast majority of market indexes, and the funds that track them, are capitalization-weighted -- meaning, the stocks that dominate the indexes at any moment are the biggest issues in terms of market capitalization (a company's share price multiplied by the number of shares outstanding).
Arnott contends that is fundamentally flawed. Why? Think about the technology companies that were paramount in the market in March 2000, at the peak of the dot-com mania.
In a capitalization-weighted index, "You automatically overweight all the overvalued stocks," Arnott says.
A better way to construct an index, he maintains, would be to weight stocks based on measures of what firms actually have accomplished, rather than solely on the often fleeting beauty contest of stock capitalization.
He calls his concept "Main Street indexing," as opposed to the "Wall Street indexing" of capitalization weighting.
The 50-year-old Arnott and his peers at Research Affiliates have spent the last few years developing an indexing system using such measures of business success as five-year average sales and operating earnings, employment and net asset value.
