Research Affiliates: Flying High: RAFI At 10 Years

May 04, 2015


The Numbahs Please

"You need a full market cycle to evaluate an investment strategy." How many times have you heard a manager or consultant intone this dictum? Well, it would be hard to argue that we haven't seen a full cycle since my revelation at 35,000 feet. We've seen a bull market from 2005 through October 2007, the sharpest bear market since the Great Depression, and a six-year bull market. Large and small companies alike have rotated leaders. As we'll explore in greater depth shortly, value won early, but growth stocks have had a nearly continuous run since mid-2007. We've also seen sector leadership shift across the economy. Seven different sectors, from health care to utilities to financials, have been calendar-year winners.


So how has the RAFI Fundamental Index methodology done in its first 10 years? What have we learned as we've migrated from the Lake Wobegon world of backtesting?


First, we have cumulative annualized performance of 9.4% from December 1, 2005, to December 31, 2014.7 How does this compare to the two implementation options of the time? Active management has had a rough go of it with a return of 7.1% for the median Lipper Large-Cap Core mutual fund, compared with 7.9% for the S&P 500. So that's an annualized excess return of 2.3% and 1.5% above the median active manager and the cap-weighted index, respectively, for our first 10 years. If you had invested $10,000 in the FTSE RAFI US 1000 Index in December 2005, your balance would have grown to approximately $22,640. This is $2,660 more than if you had invested in a fund that tracks the S&P 500 and $3,960 more than if you had invested with the median active manager. To be sure, the two index results are before costs, but the costs in both cases would have been modest.


Nonetheless, the value-added returns did fall short of the hypothetical excess returns found in the original research. Why? This brings us to the value criticism. Burt Malkiel was right. Value stocks had done very well prior to the publication of "Fundamental Indexation," whether one used the previous five years' returns (dominated by the unwind of the tech bubble) or the longer stretch of 35 years (as far back as the Russell 1000 Value data were available). And the RAFI Fundamental Index strategy had a near universally acknowledged value tilt, sometimes big and sometimes small.


In Figure 2, I show the excess returns of the RAFI portfolio over the S&P 500 along with the approximate value and size premiums that were commercially available. The first set of bars on the left shows the results that this former consultant would have looked at in 2005. The backtested RAFI portfolio produced a 2.3% excess return from 1979 to November 30, 2005. Meanwhile, value stocks, as represented by the Russell 1000 Value, produced an excess return of 0.9%. The size premium, as measured by the S&P 500 minus the Russell 2000 Index, was negative, confirming that the RAFI Fundamental Index small-cap bias was a red herring.



For a larger view, please click on the image above.



Since the launch of the RAFI Fundamental Index strategy in late 2005, value has registered a 0.6% shortfall as measured by the spread between the Russell 1000 Value and the Russell 1000 Index. The sign flipped! Yet the RAFI portfolio still produced meaningful excess returns. How did it do that? Precisely by means of its dynamic value exposure. As shown in Figure 3, the RAFI strategy entered the 2007 period with a very mild value tilt: Using the price-to-book ratio, it traded at only a 14% discount to the broad market. It had used the value rally of 2000–2006 to rebalance out of the outperforming value stocks. By the beginning of 2008, the FTSE RAFI US 1000 had half the value tilt (15% discount to the market) of the Russell 1000 Value (27% discount). It began to rebalance into value stocks in March 2008, and in March 2009 it reached a nearly 50% discount to a broad market that increasingly favored growth at any price. In a little over two years, the RAFI Fundamental Index portfolio had gone from half to twice the value tilt of the Russell 1000 Value. And it paid off.



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