Arnott: The RAFI Five-Year Scorecard

January 31, 2011


Table2 Live Annualized Returns Since Inception of FTSE RAFI


The live results fall into in the 2–4% range we discovered in our initial research. But admittedly they are at the lower end. While an excess return of 2% is respectable, why didn’t we fully match the long-term backtested results? For that, let’s turn our attention to the other major criticism of the Fundamental Index approach—the value effect.

Positive Results in a Growth-Oriented Market

Critics have contended that the Fundamental Index methodology derives its benefit from a value tilt. We don’t disagree with that view as they’re half right. Let’s explain. Suppose there are two stocks with identical sales, book values, cash flow, and dividends. The first stock, Growthy Shares Inc., trades at twice the market multiple due to its outstanding recent operating results and the investors’ resultant high expectations for future growth. Meanwhile, Unloved Value Co., with a stream of recent bad news, sells at half the market multiple. Cap weighting doubles the weight of Growthy Shares and halves the weight in Unloved Value Co., relative to their economic scale, despite the companies being the exact same size. Repeat this exercise across the whole market and the result is a strong growth tilt for a cap-weighted index portfolio. Meanwhile, a fundamentally weighted index portfolio doesn’t share that tilt to growth; it matches the look and composition of the economy. From a cap-centric point of view, the Fundamental Index portfolio does have a value tilt, but it’s a special value tilt—an exact mirror image of the market’s willingness to pay up for perceived future growth opportunities.

It is well documented that value has historically outperformed growth.4 Our own analysis has found roughly one-fourth of the RAFI method’s excess return is attributed to a static value tilt as outlined above. A majority of the excess return stems from contra-trading against the fads, bubbles, crashes, and constantly shifting expectations and speculations at work in the capital markets.

For the 21-year period ending December 2004, the global developed equity market witnessed a value premium of 1.3%, thus acting as a tailwind for the typically value-oriented RAFI performance.5


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