Research Affiliates: Flying High: RAFI At 10 Years

May 04, 2015


Learning From Valid Critiques?

Hmm…an index that stands to deliver 2% in long-term outperformance while preserving nearly all of the implementation advantages of cap weighting? Sounding too good to be true, fundamentally weighted indexing attracted immediate skepticism from Jack Bogle, Burt Malkiel, Cliff Asness…and John West. Remember, I was a consultant at the time! My clients expected me to poke holes in money managers' latest snake oil remedies. And I cared deeply about my clients' success.


Frankly, many of my concerns were similar to those expressed by Messrs. Bogle, Malkiel, and Asness, unsurprising given the deep respect I held and continue to hold for all three. Jack Bogle correctly and fairly pointed out "these are hypothetical returns for the underlying indexes that don't take into account fees, costs, and taxes" (Lim, 2007). The operative word in my mind at the time was hypothetical. We consultants had an old joke: There is no such thing as a bad backtest. They never see the light of day. I relied on my intuition. Avoiding the big bubbles like Cisco circa 2000 (or the small bubbles like Krispy Kreme Donuts circa 2003) that beset a price-weighted approach seemed promising even without simulated results. As for transaction costs, "Fundamental Indexation" demonstrated that turnover was likely to be low. Furthermore, the stocks of big companies tend to be traded in volume. As a company grows in economic importance, its target weight naturally rises, and so does its liquidity.


I was more interested in the tie-in with value. Burt Malkiel stated, "fundamental indices have done very well over the past six years because value stocks and small cap stocks have done well. Will they do well over the next six years? I'm not so sure" (Floyd, 2007). I ran the numbers, and throughout 2005 I explored the value and size issue with Research Affiliates. Jason Hsu walked me through the time-varying nature of the RAFI Fundamental Index style tilts. I became more and more aware that noisy stock prices create opportunities to rebalance. The benefits of rebalancing across asset classes are universally acknowledged, but it took the RAFI methodology to illustrate the power of rebalancing within equity markets. Rebalancing entails selling what has done well lately and buying what has done poorly. So when value stocks do particularly well relative to their fundamental size, the RAFI Fundamental Index method trims value and adds to recently lagging growth stocks.


It is precisely due to this dynamic exposure that the RAFI Fundamental Index strategy tends to win more in value markets than it gives back in growth markets. I concluded this was the driving force behind the strategy's 1.5% annualized premium over the Russell 1000 Value Index. I also concluded that the size bias of the RAFI Fundamental Index portfolio was overstated. True, the RAFI portfolio had about half the weighted average market capitalization of the S&P 500 at the peak of the TMT bubble. But that was less of a bet against large companies and more of a bet against high-priced tech stocks.


Much of the rest of the debate in 2005 and 2006 centered on semantics. Was it an index? Personally, I didn't much care what people called it. In most industries, customers celebrate innovations that deliver some combination of better performance and lower costs, rather than getting tripped up in arguments over nomenclature. Recall the two implementation choices at the time—active management and cap-weighted index funds. I concluded it was a better investment portfolio than cap weighting and it was clearly cheaper than top-quartile active managers (for those with the chutzpah to claim they can pick them).


Was it new or, as Cliff Asness (2006) suggested, just a cleverly repackaged form of value investing? Well, rebalancing—the driver of the RAFI Fundamental Index dynamic value and other tilts—is by definition a value-oriented activity, and it was identified well before Fama and French. Ben Graham (2005, p. 42) in 1949 intimated this in The Intelligent Investor by explaining, "Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal."


So what was new? Putting this kind of a value-oriented approach on a rules-based index chassis—that's what. Whether you call it an index or not, the portfolio construction methodology has critical implications. It places downward pressure on fees and upward pressure on transparency. How can that be bad?! My questions were answered. I believed this strategy was something every institutional client should examine. I figured the best way to make that happen was to join Research Affiliates as a "RAFI missionary."



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