The Patent King of Pasadena

CAPM / Alpha Theory 17 Jun 2007

Lawrence Carrel at writes about the “Godfather of Fundamental Indexing” last week.  Rob Arnott, founder and CEO of Pasadena-based Research Affiliates not only invented fundamental indexing, but he apparently also patented the idea.  As Carrel discovers, however, critics are quick to point out that fundamental indexing bears a remarkable resemblance to simple old-fashioned value-investing.

In fact, Carrel points out that ETF manufacturer WisdomTree never even sought permission from Arnott before launching their own ETF based on the same concept.  Says Carrel:

“It was also a challenge to Rob Arnott, the godfather of fundamental indexing. Arnott’s investment firm, Research Affiliates, had licensed the first ETF based on a fundamental index a year earlier and filed a patent application for all indices based on fundamentals. But WisdomTree didn’t seek Arnott’s blessing for its new products. In essence, the firm was saying that fundamentally weighted indexing isn’t the property of Research Affiliates but of the entire world.”

The patentability of business processes came to the fore late last century in the froth of the tech bubble.  In fact, Alpha Male himself even applied for provisional patent protection on an e-business process that he thought would someday make him a rich man (he still thinks it’s a cool idea).

Curious to learn more about Arnott the mad scientist/inventor/patentor we poked around the website of the World Intellectual Property Organization (WIPO) and lo and behold, there is was, Arnott’s patent on what some argue amounts to simple value investing.

(Not only has Arnott patented fundamental indexation, but he has also patented something that appears to be strikingly similar to the Unified Managed Account – the biggest thing since the SMA in the wealth management business.)

Realizing he may be in for a long and difficult fight, Arnott is apparently playing it cool.  He confides to’s Carrel:

“We’re swimming upstream on protecting our brand name, but I leave this in the hands of our ‘intellectual property’ team and don’t devote much time or attention to it…And competition is fine. But I’m less comfortable when people can’t come up with their own ideas or their own brand name for a product. But we aren’t trying to get into fights. My goal is to reach amicable agreement with those who want to pursue similar ideas.”

(Note to self: do not pick fight with any firm having a dedicated “intellectual property team”.)  Carrel continues:

“Bruce Lavine, president and chief operating officer of WisdomTree, counters that the concept of fundamental weighting has been around for 20 years. ‘There are many people who did this prior to Rob Arnott getting involved,’ he says. ‘This goes back to the late 1980s with Robert Jones at Goldman Sachs and David Morris in the United Kingdom. Barclay’s iShares developed a dividend fund in 2003 that is clearly not a cap-weighted fund. We feel very comfortable that there is prior art here in many areas.'”

In case you don’t have the time to read hundreds of paragraphs that all seem to start with “Apparatus and method for….” or “In an alternative embodiment of the invention…”, a few highlights are reproduced below.

I’m no lawyer (although I did successfully contest a parking ticket once).  But these patents seem a little extensive.  Note, for example, that the first patent applies to ALL non-cap-weighted indexing – not just fundamental indexation.  Also note that the “virtual mutual fund” patent reads like a textbook definition of Overlay Portfolio Management (a key aspect of the much trumpeted Unified Management Account).


“Apparatus and methods for automatically modifying a financial portfolio having a pre-defined universe of securities, such as, e.g., an index fund, that tracks a given capitalization weighted index, through dynamic re-weighting of a position held in each such security. Specifically, in a computer system, a target weight is accorded to each such security, relative to others in the portfolio, in proportion to a non-constant function of current capitalization weights of the securities in the index.”

“The use of these non-market capitalization metrics…allows the construction of indexes and resulting passive portfolios that better reflect the economic scale and/or long-term growth potential of the individual securities…than do conventional capitalization weighting, share price weighting, or equal weighting.”

“…may include weighting each of the plurality of assets, where each of the assets may include a stock; a commodity; a futures contract; a bond; a mutual fund; a hedge fund; a fund of funds; an exchange traded fund (ETF); a derivative; or a negative weighting on any asset.”

“…may include one or more of : revenue, profitability, sales, total sales, foreign sales, domestic sales, net sales, gross sales, profit margin, operating margin, retained earnings, earnings per share, book value, book value adjusted for inflation, book value adjusted for replacement cost, book value adjusted for liquidation value, dividends, assets, tangible assets, intangible assets, fixed assets, property, plant, equipment, goodwill, replacement value of assets, liquidation value of assets, liabilities, long term liabilities, short term liabilities, net worth, research and development expense, accounts receivable, earnings before interest, taxes, dividends, and amortization (EBITDA), accounts payable, cost of goods sold (CGS), debt ratio, budget, capital budget, cash budget, direct labor budget, factory overhead budget, operating budget, sales budget, inventory method, type of stock offered, liquidity, book income, tax income, capitalization of earnings, capitalization of goodwill, capitalization of interest, capitalization of revenue, capital spending, cash, compensation, employee turnover, overhead costs, credit rating, growth rate, tax rate, liquidation value of company, capitalization of cash, capitalization of earnings, capitalization of revenue, cash flow, and/or future value of expected cash flow.”

“In another exemplary embodiment, a machine readable medium that provides instructions which when executed by a computing platform, cause the computing platform to perform operations may include a method of constructing a non-capitalization weighted portfolio of assets…”


“A method and apparatus system for managing virtual mutual funds. A plurality of investment managers manage a plurality of accounts for a plurality of investors. The investors directly hold assets in the accounts so that the investors may take advantage of any tax benefits generated by transactions using the assets in the accounts. An investor may have one or more accounts and thus one or more managers. A manager may have one or more investors and thus one or more accounts to manage.”

“…an investor in a mutual fund does not directly hold the assets purchased by the professional manager, thus the investor loses some of the tax benefits of directly holding an asset…”

“Therefore, a need exists for an investment management system that allows an investor to take advantage of the investment expertise from a variety of professional investment managers.”

“The investors directly hold assets in the accounts so that the investors may take advantage of any tax benefits generated by transactions using the assets in the accounts. An investor may have one or more accounts and thus one or more managers. A manager may have one or more investors and thus one or more accounts to manage. A virtual mutual fund manager uses a holdings matrix and a lot matrix to track the asset lots in the accounts. When a manager wishes to make a trade affecting an investor, the virtual mutual fund manager determines which asset lots held by the investor should be used to execute the trade.”

“In another aspect of the invention, each investor may allow loss-harvesting trades to be executed on his or her behalf in circumstances where such trades may reduce the investor’s tax obligations.”

“…trades received from one or more managers are processed by selecting a plurality of lots for trade execution and aggregating any executed trades for reconciliation with the one or more managers.”

“In another aspect, an offsetting purchase of the holding is generated if it is determined that enough time has passed to avoid a wash-sale violation.”

As an aside, this 2004 article from Wall Street & Technology about Overlay Portfolio Management sounds very similar:

“Overlay portfolio management (OPM) takes the concept of multiple disciplined accounts – in which multiple money managers use the same brokerage account for trading…In theory, overlay portfolio management improves the personalization and tax efficiency of SMAs.”

“The tools allow thousands of accounts to be monitored according to individual investment policies, rules and restrictions, and enable a manager to optimize transactions and rebalancing across many individual portfolios.”

“The popularity among investors of separately managed accounts can be traced to recent publicity about the tax inefficiencies of mutual funds. The market downturn in 2000 and 2001 left many investors with huge tax bills in capital gains distributions despite falling mutual fund share prices. Investors sought more control over their portfolios, and SMAs proved a better option.”

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