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Is the RAFI® strategy really an "index?"
Does the RAFI® strategy have a bias toward value and smaller
cap stocks?
What happens when value and small-cap are out of favor?
How does the RAFI® portfolio compare with an equal-weighted
portfolio?
Is the RAFI® strategy really an "index?"
The answer
depends entirely on how one defines an “index.” From a CAPM
perspective, anything that’s not cap-weighted is neither
passive nor is it an index (although the indexing community
leans toward the decidedly non-CAPM-compliant perspective
that float-weighting is somehow preferable). By this definition,
a Fundamental Index® is neither passive nor an index. If,
alternatively, we define an index as something which is formulaic,
objective, transparent, historically replicable and low-turnover,
a Fundamental Index® qualifies on all counts. Ironically,
many of the cap-weighted “indexes” don’t qualify for this
simple pragmatic definition of an “index.”
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Does the RAFI®
strategy have a bias toward value and smaller cap stocks?
RAFI® strategies weight companies by their economic footprint.
Accordingly, it is utterly neutral relative to the composition
and weightings of business enterprises in the economy. Cap-weighting,
in contrast, has a stark growth tilt—companies at twice the
market multiple get double their economic weight, while companies
at half the market multiple get half their economic weight.
In 1997 Cisco was 0.4% of the market at 30 times earnings.
By the end of 1999 it was 4% of the market at 130 times earnings.
Did it comprise 10 times as much of the market at the peak
of the bubble because it was 10 times as attractive at a
P/E of 130 than it was at 30 times earnings? Of course not.
The weighting went up 10-fold because the stock went up 10-fold
relative to the average stock, and because it was now at
130 times earnings. A Fundamental Index® does not get drawn
into this sort of bubble, though it also doesn’t weight growth
companies more heavily than value companies even when they
deserve the higher multiples.
Cap-weighting has
a stark growth tilt relative to the composition of the economy,
while the RAFI® strategy has a stark value tilt relative
to the average composition of the stock market. Both are
utterly neutral in their respective domain!
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What happens when value
and small-cap are out of favor?
Empirically, when growth
and value have similar returns, the RAFI® strategy wins.
Why? Because it will not fall prey to overweighting overvalued
companies and underweighting undervalued companies relative
to their unknowable future prospects and true fair value.
When value is winning, the RAFI® strategy has a tailwind
and adds even more value. When growth is winning, RAFI® alpha
goes down and, in a strong growth market, can easily go negative.
To be sure, in a very substantial growth-dominated market,
cap-weighting gets such a tailwind from its growth tilt that
it is very tough to beat. Fortunately, we can have some confidence
that such markets do not go on forever and that, by the time
they are over, the RAFI® strategy will have such a strong
value tilt relative to the market that it will benefit handsomely
from the back end of from the return to value.
See the August
2007 issue of RAFI® Fundamentals for
a description of the dynamic nature of the RAFI® value and
size tilts.
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How does
the RAFI® portfolio compare with an equal-weighted portfolio?
An equal-weighted portfolio, such as the S&P 500 Equal
Weight Index, breaks the link between price and index weight
and, thus, theoretically performs very well relative to a
cap-weighted index. Unfortunately, equal-weighted portfolios
have practical limitations that make them unattractive as
investments. See the July 2007 issue of RAFI® Fundamentals.
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Overview | Methodology | Performance |
RAFI® FAQ
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