Arnott: The RAFI Five-Year Scorecard

January 31, 2011

 

In opposite fashion, value acted as a headwind during the live period. In the United States, large-cap value stocks returned +1.4% from November 30, 2005, through December 31, 2010, while their growth counterparts were up +3.6%.6 Thus, the negative premium for value stocks has been about half of this 2.2% difference per year in the United States. Similarly, in developed markets, the value premium was –1.1% per year for the past five-plus years (See Figure 1).

 

Figure1 RAFI Excess Returns & The Value Premium

 

Our simulated results showed an average RAFI excess return of 2.7% per year vis-à-vis cap weighting in a period of 1.3% value outperformance, so clearly RAFI performance is more than just value. The RAFI live index results have been even more impressive, achieving 2.0% excess returns during a time when value indexes lagged the broad markets by more than 1% per year! The RAFI approach beat the cap-weighted value benchmark by well over 300 bps, winning while value was losing, compounded over five years.

How is that possible? One of the important features of the RAFI investment process is the annual reconstitution back to a company’s fundamental scale as defined by a composite of sales, cash flow, book value, and dividends. This rebalancing, a key differentiator of RAFI indices, forces the portfolio to trim stocks whose prices recently outperformed their fundamentals and add to those stocks whose prices have underperformed the businesses’ economic footprints. The market is constantly changing its mind as to which companies are growth stocks and which ones are value stocks, and how much premium or discount each company deserves. A conventional value index responds by adding and dropping companies as they fall in or out of the value camp; but the weight is always the cap weight if it’s in the index. A Fundamental Index portfolio will adjust over- or underweights relative to the cap-weighted market to reflect the constantly changing premium or discount reflected in the share price. The size of the business is merely a convenient, and economically meaningful, anchor to use for rebalancing.

On a style basis, the RAFI approach increases its value exposure when value has recently underperformed and is cheap (i.e., investors are rewarded with a high forward-looking value premium). This phenomenon was vividly seen in 2009 when the RAFI strategies—oblivious to imminent Armageddon—rebalanced into the very finance, industrial, and consumer discretionary stocks that were ostensibly poised for extinction. Meanwhile, the RAFI approach reduces its value exposure when value has recently outperformed and is expensive. This contra-trading process is the reason why a value-tilted portfolio can win—even handily—in a secular growth led market.

 

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