The value-oriented investor, still in the throes of a long harsh winter, should be heartened in the knowledge that summer will inevitably arrive on the predictable warm breeze of mean-reverting valuations.
The rapid rise and sharp decline of the A-shares market represents a massive redistribution of wealth, especially painful to uninformed investors who bought hot stocks near the peak. What should the Chinese government do now?
Benjamin Graham’s well-reasoned, rules-based approach to security analysis remains,
after more than 80 years, a cornerstone for building a strong, long-term
investment program to meet investors’ financial goals…
Some of the investment industry’s best thinkers discussed their work at a Research Affiliates meeting. Jason Hsu’s report emphasizes that factor-based investing is incomplete unless it’s paired with an asset-based approach.
Investors might apply advanced techniques of quantitative analysis to discriminate between genuine premium-bearing factors and the spurious products of data-mining—but here’s a three-step heuristic.
In 2005, equity investors had a stark choice: Try to find a skillful active manager, or place assets in a cap-weighted index fund and accept the market return. But a seminal research paper described a new approach—one that is known today as smart beta investing. John West tells the story.
What is smart beta, how does it differ from traditional investing, and what sources of long-term excess return can it capture? Exploring Smart Beta presents Jason Hsu’s insights in an engaging format.
The excess return earned by the average investor in value mutual funds was meaningfully negative over a 23-year period when the funds themselves outperformed the market. Why don’t all value investors benefit from the value premium?
The value premium neither widens and narrows uniformly across countries nor moves in sync with major asset classes. A fundamentally weighted long-short strategy might be a sensible addition to a diversified asset mix.
The size premium—the outperformance of small-cap stocks—has been a fixture in factor investing for an entire generation. But a critical examination of updated evidence from the United States and 17 other countries throws its very existence into question.
Smart beta strategies can be combined in a core-satellite structure for potential excess returns with lower estimated risk. This white paper describes the hypothetical interaction of fundamentally weighted, low volatility, and momentum strategies.
Transparent, rules-based smart beta strategies preserve many of the benefits of traditional “first generation” passive investing. This article explains how they can also deliver long-term returns exceeding capitalization-weighted indices—including value style benchmarks—at significantly lower cost than active management.
The FTSE RAFI® Index Series was launched in 2005. This white paper sets forth the rationale for fundamentally weighted indices; examines the FTSE RAFI methodology; and reviews index characteristics and performance.
The publish-or-perish syndrome and the smart beta movement have motivated academics and practitioners to come up with a spate of new factors. How can investors determine which ones are legitimate and how to use them in their equity portfolios?
Smart beta strategies capture the value premium more efficiently than traditional value style indices. This article compares the two approaches and explains how smart beta’s rebalancing rule effectively carries out dollar cost averaging.
There’s a lot of negativity about emerging market stocks—so it makes sense for long-term, value-oriented investors to rebalance into the asset class. Here’s why a systematically contrarian strategy like fundamentally weighted indexing might outperform.
Comparing the investment results of equal- and fundamental-weight strategies, both gross and net of indirect costs, reveals how the implementation of smart beta strategies can affect performance.
Due to the variability of common stock valuation levels, the emerging markets illustrate with unique clarity how smart beta strategies work. This white paper analyzes the impact of active sector weights that naturally arise from smart beta strategies’ bottom-up portfolio construction and rebalancing processes.
Not all smart beta strategies are created equal. Although both equal-weighting and fundamental-weighting strategies earn long-term excess returns over capitalization-weighted indices, they differ in their performance and cost structure. We take a look at the dissimilarities.
Russian stocks declined sharply since the Ukrainian crisis broke. But experience in other recent regional crises suggest that investors should not pull back from Russian equities.
Measuring the "Skill" of Index Portfolios
Investors devote significant resources to deciding whether a manager is skillful. When it comes to passive investing, they appear to lose their critical faculties.
Contrarian investing simply comes down to buying low and selling high. What personality traits does it take to handle the stress of standing against the crowd?
The Glidepath Illusion...and Potential Solutions
Classic glidepaths built in target-date strategies are flawed: they neither deliver more end-point wealth nor provide greater certainty for retirement income than alternative strategies.
Low volatility investing has garnered strong investor interest. Why does it work? Where does it fit into portfolios? This paper explains the benefits and drawbacks of the strategy.
A low volatility strategy constructed by combining the return-enhancement engine of the fundamentals-based methodology with a low volatility design, attains a superior Sharpe ratio while achieving lower turnover, higher investment capacity, relative transparency, and broader market representativeness than alternative approaches.
Why do low volatility stocks outperform riskier ones over time? This article summarizes four complementary hypotheses that explain the low volatility anomaly, and explains how low vol portfolios offer improved risk-return profiles to traditional capitalization-weighted core portfolios.
Over the last five years, a new class of equity index products known as strategy indexes, or smart betas, has emerged. These strategies are non-cap-weighted index strategies based on transparent quantitative methodologies. Investors choosing among smart betas should consider if they are more sensitive to volatility or benchmark risk.
Traditional risk parity strategies are based on equal risk weighting of selected asset classes. The method seeks to equalize the risk contribution by the asset classes in an asset allocation portfolio. The intuitive appeal of this asset allocation scheme is in its iimprovement in asset class diversification versus the traditional strategic asset allocation ...
The European sovereign debt crisis is roiling global financial markets. This scenario may seem obvious in retrospect: profligate nations with high deficits and a history of devaluation committed themselves to issuing debt in a hard currency beyond their control--what other outcome should we have expected?
Young adults should buy stocks; mature adults should favor bonds. Or so we’re taught. But the Glidepath—the mechanism within popular target-date funds that shifts asset allocation to bonds from equities as participants age—does not lead to optimal returns.
Value stocks typically enjoy higher dividends than growth stocks. Growth stocks, on the other hand, typically enjoy faster dividend growth. What most investors miss is that a portfolio of value stocks generates faster growth in dividends than a portfolio of growth stocks.
An investment consultant with Towers Watson thinks the Fundamental Index methodology might be an important innovation. But he has some concerns about its suitability for the firm’s institutional clients, according to this case study from the University of Virginia’s Darden School of Business.
Research makes a compelling case that investors should rebalance their portfolios, yet most investors do not do so. Why not? The answer is less about “behavioral mistakes” and more about the fact that “rational” individuals care more about other things than simply maximizing investment returns.
Most people tend to measure wealth in terms of the dollar value of a portfolio. We believe it is better to measure wealth in terms of the real spending the portfolio can sustain over the entire life of the obligations served by the portfolio. We call this approach “sustainable spending.” But focusing on sustainable spending requires real courage.
Professional investors have emotions, too, ones that may prevent them from making the best decisions for their clients. This lack of discipline affects not only traditional active managers, but also black box quantitative managers and the market as a whole. In contrast, Fundamental Index® strategies adopt a systematic, rules-based, and dispassionate ...
Last year, securities prices moved like a school of sardines. With little cross-sectional mean reversion and a value headwind, this environment made life difficult for both active managers and the Fundamental Index approach. In this issue, we examine what happened in 2011 and the opportunities for breaking loose this year.
There is an alternative to traditional passive and active equity allocations—“alternative” beta” or “strategy index” options. Our research on this subject compares seven leading alternative beta strategies. The results—originally published in the Financial Analysts Journal--may surprise you.
The price of a stock may differ from its fundamental value by a random noise. In this case, small-capitalization and value stocks are more likely to have negative noise, while large-capitalization and growth stocks are likely to have positive noise. Negative price noise implies that small-capitalization and value stocks are more likely undervalued and ...
After reviewing the methodologies behind the more popular quantitative investment strategies offered to investors as passive equity indices, the authors devised an integrated evaluation framework.
An important contributor to performance for any portfolio is the selection of companies for inclusion, no less so for indexes than for active portfolios. Rather than exploring this topic broadly, as many have done, we focus on the differences between two well-known lists of companies: the Fortune 500 and the Standard & Poor's (S&P) 500.
August 2007 deserves more attention by today’s investors. Analyzing the underlying causes of the quant meltdown helps reveal the perils of complex quantitative strategies and highlights the difference between transparent and rules-based alternative beta strategies such as the Fundamental Index methodology and newer optimized approaches.
Investors typically use one of three “standard” strategies to construct their equity portfolios: 100% passive management using a cap-weighted index, 100% active management, or core-satellite, a combination of passive and active management. We suggest an alternative approach, but it requires some “out-of-the-box” type thinking.
The selection of active managers is an exhaustive and time-consuming activity. Certainly, some investors rely on track records to gauge skill but “past performance is no guarantee of future results.” Selecting a manager requires separating manager skill from pure luck. Unfortunately, this is easier said than done.
Why does the Fundamental Index methodology overweight and underweight certain sectors? What’s the rationale? In fact, such structural sector bets, don’t matter over the long term. The RAFI strategy can be wrong on average but right in the long run because of its ability to contra-trade against market fads, crashes, bubbles, and speculation.
In the five years since the launching of Fundamental Index strategies as live portfolios, the effectiveness of the strategy and source of its outperformance have been strenuously debated. The initial research by Arnott, Hsu, and Moore  presented the concept as a simple quantitative way to sidestep a crucial shortcoming of cap-weighted indexin ...
It is often said that the devil is in the details. We examine three seemingly innocuous construction details of the Fundamental Index methodology that can have sizeable impacts on performance and help distinguish the RAFI approach from other fundamentally weighted indices. The bottom line: Details matter.
At the bare minimum, a benchmark index should measure the performance of an investment strategy or asset class. But as far as investors are concerned, although most fixed-income indexes meet this threadbare requirement, they fail miserably on most other counts.
When the Fundamental Index concept was introduced, critics decried its backtested results as data-mining or said the approach was just repackaged value investing. Five years after the first RAFI indices went live, the proof is in: The methodology has generated superior performance during a period when value has lagged growth all over the world.
We live in a world profoundly addicted to debt-financed consumption. For most of us, our first car and our first home were financed with debt. We borrowed with intent to repay, and most of us did just that. We were, of course, no richer because we'd just borrowed to buy a house or a car: We had a new asset, exactly offset by a new liability.
How can investors meet their return targets in a world of low stock and bond yields? The solution requires abandoning the classic 60/40 blend of stocks and bonds and adopting an asset mix different from one’s peers. Taking these steps is not comfortable, but comfort is rarely rewarded.
For investors using a core-satellite approach to strategic asset allocation, traditional style indices, such as value and smallcap indices, represent convenient passive vehicles for achieving strategic or even tactical portfolio tilts.
In historical testing, valuation-indifferent indexing produces statistically significant and economically large outperformance relative to traditional capitalization-weighted indexes. This result has been found for both U.S. and global equity data, as well as U.S. corporate bonds and emerging market bonds.
The U.S. stock market has gyrated between value and growth in recent years. Is there a better way to invest than having a 50/50 split between value and growth? Because of its rebalancing process, the Fundamental Index® strategy resembles a deep value portfolio after strong growth runs and has a mild value orientation after value outperforms.
Deficits, debt and demographics are creating structural headwinds for most developed markets. But investors in emerging market equities have not been rewarded for the risk they have taken on—at least not as measured by cap-weighted indices. We believe this weak performance results from the return drag from capitalization weighting.
Valuation-indifferent weighting has gained significant interest as a strategy for creating alternative indices or quasi-indices. The weighting scheme has empirical support from Arnott, Hsu, and Moore  and many subsequent papers extending their approach.
Will Rogers once quipped, “Popularity is the easiest thing in the world to gain and it is the hardest thing to hold.” The top of the capitalization-weighted index is filled with companies at their peak popularity, many of whom fall out of favor. In contrast, the Fundamental Index approach avoids fads and bubbles.
In the last decade, the S&P 500 Index landed in the 90th percentile compared to a universe of U.S. large-cap core equity managers. But the figures can be misleading. When you take out survivorship bias, backfilled data, and fees, active managers look a lot less attractive.
The outlook for the ubiquitous 60/40 blend of stocks and bonds remains bleak. The key to better returns hinges on shifting risk exposures: We choose to take long-term risk when risk-bearing is likely to be rewarded, and a conservative, well-diversified posture when it is not.
For over 40 years, our industry has relied on the capital asset pricing model (CAPM) beta and the capitalization-weighted market portfolio for asset allocation, for market representation and for our default core equity investments. This elegant worldview is now under siege from various directions.
Stocks are generally used to provide higher returns in the long run. But the dramatic fall in equity prices at the beginning of this century, triggering large underfundings in pension plans, raised the question as to whether stocks can really help mend the asset and liability mismatch.
The naughts were the worst decade ever for U.S. equity investors, even after an astounding rebound in the past 10 months of 2009. The picture grows far worse when we incorporate typical pension liabilities and 401(k) plan target returns. But did the picture have to be so bleak?
Are the FTSE RAFI portfolios adding value or is capitalization weighting underperforming? The answer depends on the frame of reference. From an economic frame of reference, the cap-weighted market is an active growth-tilted portfolio with the RAFI approach contra-trading against these constantly changing market bets.
The value effect, in which value stocks significantly and consistently outperform growth stocks for investors who are patient enough to ride out the often-extended periods of growth dominance, has been a topic of discussion within the investment community for more than four decades.
Did avoiding overconcentration of stocks in the portfolio, periodic rebalancing and not chasing winners help avoid negative alpha in the Global Fiscal Crisis and its aftermath? ? In each case, the answer is yes. Investors can take simple steps to avoid these drags on returns.
For four decades, from time to time, we hear this question: Why bother with bonds at all? Bond skeptics generally point out that stocks have beaten bonds by 5 percentage points a year for many decades, and that stock returns mean-revert, so that the true long-term investor enjoys that higher return with little additional risks in 20-year and longer ...
Rob Arnott, Feifei Li, and Katy Sherrerd recast a stock’s ex post realized value as its “clairvoyant value,” that is, the value that investors with perfect foresight would have placed on the company at the beginning of the measurement period. Their findings provide intriguing historical evidence on the value effect as well as the efficiency of the stock ...
Many people argue in favor of active management over passive management because they believe that “experts” actively managing a portfolio will be able to outperform the relevant passive alternative. We believe that disappointing performance by active managers in 2008 will reignite the active-passive debate.
The Fundamental Index advantage arises from breaking the link between prices and portfolio weights. This advantages comes from the strategy’s value tilt and maintaining a steady weight for a stock over time, providing an objective and rational anchor for rebalancing. Over the short term, however, investors may experience a bumpy ride.
Few topics have captured the attention of index investors more during the past decade than that of fundamentally weighted indexes. The core idea is simple: Advocates of fundamentally weighted indexes argue that you can significantly improve the risk-adjusted returns of an index-based strategy simply by weighting the index by a factor other than price. ...
In 2008, the S&P 500 Index posted its worst year since 1931 and virtually all risky asset classes produced breathtaking losses. But this dramatic decline in valuations will reveal a host of opportunities for both GTAA and Fundamental Index® strategies.
When the 2000 bubble burst, many of us characterized it as a “perfect storm” for pensions: the falling yields boosted the mark-to-market value of the pension liabilities hugely, while falling stocks crushed asset values. This left us with sharp erosion in funded ratios. The question is: What can be done?
Emerging market equities have been savaged in the bear market of 2008 as the financial crisis has morphed into a nearly certain global economic slowdown. But with the category’s “half-off sale” comes a potentially rewarding entry point for long-term investors willing to cope with high interim volatility.
In a volatile market, two approaches provide insurance against price reversals—a disciplined, relative-value approach to asset allocation in the broad capital markets and an indexing approach that anchors on metrics of fundamental size rather than capitalization. Both are critical in the face of an uncertain and unsettling investment environment.
Are markets efficient? The answer depends on who you ask. Market efficiency advocates favor indexing while inefficient market believers prefer active management. However, there is a third choice between the hollow promise of active management and the propensity of traditional index funds to ignore mispricing.
The expected value added from the Fundamental Index strategy rises in inefficient markets, making it an attractive alternative to traditional active management. Yet, unlike active managers, the Fundamental Index strategy maintains the broad coverage, high capacity, and low fees reflecting the positives of index implementation.
Traditional indexers argue that the Fundamental Index strategy is a new form of active management and that only the cap-weighted portfolio is passive. However, a more pragmatic definition of an index suggests at the Fundamental Index portfolio is an index, or at least a passive strategy, while most cap-weighted indices fail the test.
We model a continuous time one factor economy where stock prices are noisy proxies of the informationally efficient stock values.
It might seem perverse, after a week when global stock markets slipped into panic mode, to consider the merits of a new way of calibrating the market's performance that can realistically only prove its value over the longer term. The one thing we know about panic sell-offs, however, is that they always create opportunitites for bargain-hunters with ...
In a growth-oriented market, the RAFI strategy outperformed value strategies and most quantitative enhanced index strategies. Our “live” three-year track record shows that when value beats growth, the RAFI strategy captures 30–70% of the differential; when growth beats value, the RAFI strategy’s shortfall is only 20% of the differential.
Investing in index-based ETFs has become popular with both retail and institutional investors. Reasons include the fact that index-based funds consistently outperform those that are actively managed, are cheap, and are easy to understand.
Traditional benchmarks like the Standard & Poor's 500 index habitually overweight overvalued stocks and underwight undervalued stocks, leading to a performance drag. Fundamentally based indexes correct this shortcoming by reweighting benchmarks in a way that is willfully ignorant of market cap. So why all the controversy?
Since the initial circulation of Fundamental Indexation research in mid-2004, the concept has spurred great interest and debate in the investment community. At its core, Fundamental Indexing argues that cap weighting systematically overweights overvalued stocks and underweights undervalued stocks in a portfolio, which leads to a return drag in traditional ...
In this paper, we show that under a fairly innocuous assumption on price inefficiency, market capitalization weighted portfolios are sub-optimal. If market prices are more volatile than is warranted by changes in firm fundamentals, then cap-weighted portfolios do not capture the full premium commensurate their risk.
Indexing is a powerful model for equity investing. It is inexpensive to implement and absolutely transparent. The strategy has immense capacity, is highly liquid and is naturally well diversified. More importantly, there is overwhelming evidence that index investing, in the long run, outperforms active investing.
In this report, we present the new concept of fundamental indexing developed by Robert D. Arnott et al (2005). Fundamental indexing assigns index weightings to stocks based on the use of fundamentals that are not tied to share prices, rather than using the commonly accepted method of assigning index weightings based on market capitalization.
The finance community has published thousands of articles and doctoral dissertations exploring the size effect, the value effect, the momentum effect, and various combinations and permutations of the three‑now often referred to as the "Fama-French factors."
By the end of the 20th century, even casual investors had become comfortable with the idea of index funds. The idea of a better index fund (see Arnott, Hsu, and Moore 2005), however, is mind-boggling. This article offers one man's view of why it will actually work.
A trillion-dollar industry is based on investing in or benchmarking to capitalization-weighted indices, even though the finance literature rejects the mean–variance efficiency of such indices. This study investigates whether stock market indices based on an array of cap-indifferent measures of company size are more mean–variance efficient than those ...
If we earn 50 percent this year and then lose 50 percent next year, are we back where we started? Of course not. We are down 25 percent. This trivial truism has many implications, some simple and some profound.
Look at stock prices during the Tech Stock Bubble of the late 1990s and its subsequent deflation and the nightmarish collapse of banking stocks during the Global Financial Crisis. Capitalization-weighted equity indices incorporate these inefficiencies, overweighting overpriced stocks and underweighting undervalued stocks. These inefficiencies lead to a drag on returns of about 2% a year in developed markets and more in less efficient markets, according to our research.
In contrast, RAFI Fundamental Index equity strategies select and weight securities by their fundamental measures of size. They offer the opportunity to achieve superior performance while retaining the benefits of traditional passive investing—broad market exposure, diversification, liquidity, transparency, and low cost access to equity markets.
Fundamental Index strategies have a value tilt and a slight small-cap tilt. These tilts, however, are dynamic: When value stocks are out of favor and thus are cheap, Fundamental Index strategies tend to increase their allocation to deep value stocks. This phenomenon was vividly displayed in March 2009 when financial, industrial and consumer discretionary stocks were priced at bargain-basement levels. When value is in favor, the value tilt is much milder because these stocks tend to be priced higher. Rebalancing into unloved stocks and out of the most popular stocks—which we call "contra trading"—provides the majority of RAFI strategies' added value.
RAFI Fundamental IndexThese strategies are appropriate for core equity portfolios. They can be used as an alternative to traditional index funds and as a complement to active management. FTSE and Russell, leading global index providers, calculate respective index series using the Fundamental Index methodology. The index series are available for U.S., global, emerging markets, and many individual countries.
Long/ShortThe RAFI US Equity Long/Short Index offers an absolute-return option in the RAFI series of indices. The index has produced equity-like returns that are uncorrelated to equities, fixed income, and even other absolute-return strategies at somewhat lower risk levels, based on simulations. Please see the factsheet for more information.
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