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Rob Arnott.

Rob Arnott has turned the practice of buying the market on its head. His fundamental indexing approach weights stocks on factors such as book value and cash flow, rather than stock prices. And, just as index investing beats most stock picking, fundamental indexing is beating them both.

Fundamental indexing has been attracting a lot of attention for outperforming traditional indexes. Is it also attracting more criticism?

Actually, I think it has been silencing the critics. The idea has been live for close to nine years, and it has worked. It has added 1.5% to 2% per year, compounded annually, across a whole array of markets. The simple fact is, fundamental indexing wins because of contra trading against the market's most extreme bets. Whatever the market is chasing most aggressively as a fad, that's what we're trading against. Whatever the market is shunning, that's what we're buying.

Is fundamental indexing supposed to replace traditional indexing?

They are highly complementary. I can't imagine ever investing in a cap-weighted strategy again, but there are times when growth is in favour and fundamental indexing will struggle. So for most investors, having a bit of both probably does make sense.

As an indexer, do you have views of the year ahead?

Absolutely. We think value in emerging markets, perhaps best illustrated by fundamental indexing, is really, really cheap. So to the extent that investors want equity investments, we think this is a wonderful time to fade their exposure in the U.S. and developed economies, and to rebalance into the deeply out-of-favour and unloved emerging markets. Emerging market debt has also fallen out of favour and is priced way out of proportion to the default risks. And we think that high-yield bonds still represent a modest opportunity.

Where do you stand on whether U.S. equities are heading into a bubble?

I think the word "bubble" is overused. I would characterize the U.S. stock market as expensive. Could it become a bubble? Yes, but buyers today are basically betting on two things. One, that it goes from expensive to bubble; and two, that they'll recognize the difference and will sell after the bubble has matured. Those are two very aggressive assumptions. I'd much rather sell out of an expensive market and buy into attractively priced markets, rather than playing the game of picking up nickels
in front of a steamroller.

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