The RAFI® (Research Affiliates Fundamental Index®) methodology was developed to address the structural return drag created by traditional capitalization-based indexing strategies, which systematically overweight overpriced securities and underweight underpriced securities. Sophisticated institutional investors are seeking exposure to alternative betas such as Fundamental Index strategies to address the inherent problems with market-weighted passive investment approaches.

According to our research, the return drag associated with this structural flaw is 2% to 4% per annum for large company stocks in developed markets over long time periods and higher for less efficient parts of the market, such as emerging market equities.

The return drag of capitalization-weighted indexes is caused by the linkage between a company’s stock price and its weight in the index—that is, a company whose stock price is overvalued will have too high a weight in the index, causing it to underperform as the stock price corrects. Conversely, an undervalued stock will have too low a weight in the index, and will outperform as its price recovers.

For bonds, the argument is equally compelling. Traditional bond indices tend to give the greatest weight to those companies or countries that issue the largest amount of bonds, with no relation to the issuers’ ability to meet those obligations. Why would you load up on obligations from the biggest debtors?

Our research shows that applying the RAFI methodology to U.S. high-yield bonds would have generated more than 2% per annum in added value for the 23-year period ended December 2009. U.S. investment-grade and emerging market debt also would have outperformed traditional indices.

For both equities and bonds, the award-winning Fundamental Index methodology severs the link between price and portfolio weight, reducing the effect of mispricing of securities.

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