Research Affiliates: Elegant Design

December 15, 2015

The third strategy, the dividend yield–weighted strategy, allocates weights proportional to yield. As a result, its yield is higher than the yield of the equally weighted strategy, but without a commensurate gain in liquidity.

So, where does this leave investors? With limited options, investors find themselves between the proverbial rock and a hard place, forced to prioritize two equally valued characteristics of yield and liquidity.

Under the AND principle, however, this trade-off between capacity and yield is largely unnecessary. We believe investors can have both preferences in one product by applying a fundamental weighting approach that intrinsically provides an excellent proxy of liquidity (it assigns larger weights to larger companies on the basis of accounting measures). And unlike capitalization weighting, the fundamental weighting approach is not inversely proportional to company yield.

The RAFI equity income strategy first weights sectors by fundamental weights; then, within sectors, it multiplies the weight of each company by dividend yield to increase the future yield of the strategy. As Figure 4 illustrates, this weighting scheme provides investors with both high capacity and high dividend yield pick-up.


Research Affiliates: Elegant Design

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In Closing

In our view, it is not enough for the investment industry to come up with product ideas that meet investors' financial needs; products that are genuinely useful should additionally be designed for simplicity and cost-efficient implementation. (We shouldn't have to add that they should also be priced fairly, with most of the excess return passed along to the investor.) Drawing inspiration from Steve Jobs, we further apply the AND principle to our index design initiatives: we look for ways to build in desirable features that might, at first glance, appear to require compromises. The simulated RAFI equity income index described here is a case in point: it is designed to provide capacity, quality, and yield without trading one off against the other.

 

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