Arnott: The RAFI Five-Year Scorecard

January 31, 2011

 

The contra-trading impact is illustrated in Figure 2, which shows where RAFI excess returns are plotted given the value premium for the five years of live performance. The dashed line that starts in the lower left quadrant and rises to the right is how the Fundamental Index approach would have performed if it were a pure value strategy. Points above the dashed line are one-year periods when the RAFI strategy beats the pure value approach; points below the line are one-year periods when the RAFI approach loses to the pure value strategy.

 

Figure2 Impact of Contra-Trading, 2005-2010

Two things stand out. First, the RAFI approach generally plots above this dashed line…it beats the straight value strategy. Overall, the live batting average—or success rate—of RAFI wins is 80% of one-year periods. Second, the RAFI strategy outperforms as frequently when growth wins (the left half of the chart) as when value wins (the right half of the chart).

Conclusion

The Fundamental Index methodology does not work all the time; no investment process does. However, our research found that, over full market cycles, the RAFI methodology is strikingly effective at adding value over the cap-weighted benchmarks. A live five-year win rate of 83% in developed markets—during a span of substantial value underperformance when critics said the Fundamental Index methodology should have lost—is powerful evidence

Any new scientific hypothesis—or backtested analysis—warrants a skeptical look. The Fundamental Index idea is no exception. We think the live results, however, provide strong empirical evidence that the RAFI idea holds merit and will begin to open the minds of many of the early disbelievers. Further, these results suggest that RAFI strategies can play an important role as a low-cost “core” part of your equity portfolio—a better beta achieved with all of the advantages of traditional cap-weighted indexes.

 

Endnotes

1. Robert D. Arnott, Jason Hsu, and Philip Moore, 2005, “Fundamental Indexation,” Financial Analysts Journal, vol. 61, no. 2 (March/April): 83–99.

2. H. Tamura and Y. Shimizu, 2005, “Global Fundamental Indices: Do They Outperform Market-Cap Weighted Indices on a Global Basis?” Nomura Global Quantitative Research (October 28).

3. The statistician in me must admit this is fortuitous. While it is dead on with our historical average, the range of all five-year excess returns from the 1960s is considerably wider and investors should not assume all or even most five-year holding periods would produce such a similar outcome.

4. Eugene F. Fama and Kenneth R. French, 1992, “The Cross-Section of Expected Stock Returns,” Journal of Finance, vol. 47, no. 2: 427–465.

5. Calculated by MSCI World Value Index (13.0%) – MSCI World Index (11.7%) from January 1984 through December 2004.

6. As measured by the Russell 1000 Value and Growth indexes.


© Research Affiliates®, LLC 2011. The material contained in this newsletter is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any securities transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. Neither Robert D. Arnott nor Research Affiliates and its related entities warrants the accuracy of the information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this newsletter is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this newsletter should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

ROBERT ARNOTT, Chairman and Founder of Research Affiliates, LLC.


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