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Traditional market cap weighted indexes like the S&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 Barnott, 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 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? 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 expensive, it's 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 50s as investable portfolios to the 70s, and growth indexes to the late 70s and 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 and weights 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 30 years would have outperformed Russell growth by four and a half percent per annum going back almost 30 years.

Russell growth, not Russell value. 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&D. Explain what goes in to the RAFI growth index.

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 FAJ, 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, 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, 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 is 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 RAFI growth index. Really? Which two? Take a guess.

So who's cutting way back on their R&D and not seeing increases in revenue? you? Apple and Amazon? I'm just spitballing. You got one out of two.

So Apple is the first one? 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 RAFI growth index. The indexes on Bloomberg has been since last March, 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. 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?

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 RAFI 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. 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. Wow. Huge. 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 tenfold, and if you weight it by that tenfold growth,

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. 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? 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 going to underperform by about 2. In a normal excellent year, it's going to outperform by about 12. So since we launched 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. But if you go back, you find that it wins about seven out of 10 years. 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 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. 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 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 give us something on the order of one

and a half to 3 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 just redefining its constituents based on what is best working today? What is seeing the highest increases in revenue profits and research and development spending?

Well, between RAFI, the fundamental index, which has stark value tilt, and RAFI 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 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 Rafi 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.

I'm so glad you said that because when do you ever see a bad backtest, right? All backtests are great. I see lots of bad backtests that I would never promote. The backtests that get shared are the ones that there's a little... Of course they are. Totally. And 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 many backtests that look great fail to perform in real

life because the world changes. And if you're doing a backtest to create a better backtest, right that's right that's the that's the epitome of data mining and it's

endemic in our business. 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.

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

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.

Take a load off, Randy. And you put the load right on me.

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