Nearly 10 years ago, what we now call the promise of smart beta1 began for me at 35,000 feet over the Kansas–Missouri border. In April 2005, well before smart beta or its cousin, factor investing, had become everyday expressions, I found myself on a transcontinental flight, completely and utterly … bored. At the time, I was director of research at an investment consulting firm and, feeling totally prepped for my client meeting, I had next to nothing to occupy the last two hours of my flight (the SkyMall catalog was never good for more than two or three minutes of perusing). So I dug into my briefcase and found the one piece of reading left, the March/April edition of the Financial Analysts Journal.
Considering that two of my current partners were associated with the journal in 2005—Rob Arnott was editor and Katy Sherrerd was a managing director of CFA Institute responsible for the FAJ—you'd think I would tell you (and them) that I anticipate its delivery like an 11-year-old boy waits by the mailbox for the latest issue of MAD magazine. But I'd be lying. Aside from Rob's "Editor's Corner" columns, the FAJ would normally get a skim at best. Not this time. The skimming stopped at an article called "Fundamental Indexation" (Arnott, Hsu, and Moore, 2005). I read, pondered, and reread. The notion of a better index was mind-blowing, a real game changer for institutional investors staring at low long-term returns. So, upon returning from my trip, I called the Research Affiliates main line (then in Pasadena). It was the only reverse inquiry I made in a decade of investment consulting. Less than a year later, I left my comfortable and enjoyable consulting career, lengthened my commute by 35 miles (right through downtown LA … in rush hour), and joined Research Affiliates.
So how has it turned out? Well, I'm loving things here at Research … oh, you meant with the RAFI Fundamental Index™ strategy and its investors, didn't you? I'm pleased to report quite well. Join me as I explain how it went and where we are headed.
The Choices Then
In 2005, an investor allocating any amount of assets to equities faced a binary choice: invest actively or passively? Active managers pointed out, quite correctly, that prices (see TMT Bubble)2 deviate wildly from fair value, and a capitalization-weighted index will structurally allocate more to overpriced stocks. The indexers countered with the indisputable Cost Matters Hypothesis (CMH), the obvious fact that for every winning active manager there must be a losing active manager taking the other side of the winner's trades, as well as overwhelming empirical evidence on the superior performance of cap-weighted index funds.3 There was no viable low-cost solution that fixed the return drag from cap weighting while retaining many of the benefits associated with indexing, such as capacity, economic representation, and ease of governance.4
The experience of the late 1990s and the bursting of the tech bubble vividly illustrate this paradox. Figure 1, an exhibit we've used before, outlines the rise and fall of Cisco Systems during this stretch of time. In all honesty, we could have chosen almost any tech company in virtually any country. As they all crested, proponents of active management hollered that the index was taking people on a dangerous ride. And they were right. To this day, most people don't realize that the average stock in the S&P 500 Index5 didn't begin to lose money until April 2002, a full 20 months after the bear market had started for its cap-weighted cousin. Did active managers take advantage of the opportunity? Nope. Over the preposterous Cisco mispricing cycle, the S&P 500 still managed to outperform the majority of mutual funds.6 Massive pricing errors and the associated return drag from cap weighting, but no excess returns? For shame.
For a larger view, please click on the image above.
The RAFI Fundamental Index approach sought to solve this conundrum in a shockingly simple and intuitive manner. Suppose we weighted our index by some other gauge than price. We would no longer be forced to ride up with the most popular and beloved stocks, and the exorbitant expectations that come with them. Arnott, Hsu, and Moore (2005) proposed using other measures of economic size, like sales, cash flow, book value, and dividends paid, and then rebalancing once per year. They showed how this and other non-cap-weighted indices plugged the "2% leak" in the cap-weighted boat, by breaking the link between price and portfolio weight. But unlike other measures—crude ones like equal-weighting back then and the opaque and overly complicated "quant in drag" techniques today—the use of economically meaningful measures preserves virtually all the desirable attributes of cap-weighted indices, including broad economic representation, large capacity, low turnover, and ease of governance.