Smart beta strategies, including those in the Russell Fundamental Index® series, are designed to add long-term value by means of a simple mechanism: periodically rebalancing portfolio holdings to weights that are not based on market prices. This approach to index-based investing tends to underperform when momentum dominates the market and outperform when stock prices revert toward their long-term averages. In this paper, we present evidence on the effectiveness of rebalancing to position emerging market portfolios for superior long-term results. Due to the variability of common stock valuation levels, the emerging markets illustrate with unique clarity how smart beta strategies work.
After explaining how the Fundamental Index™ methodology can be expected to affect performance in principle, we compare simulated and actual returns of the Russell Fundamental Emerging Markets (EM) Large Company Index with the historical returns of the capitalization-weighted Russell Emerging Markets (EM) Large Cap Index. (Returns for periods prior to the launch of the Russell Fundamental Index series are hypothetical.) Over a 17-year interval, the fundamentally weighted index outperformed the cap-weighted benchmark by more than 600 bps annually with virtually identical ex post volatility.
Then, in order to determine the sources of value-added returns in emerging markets, we conduct year-by-year sector attribution analyses for the 2009–2013 period—a timeframe in which the annual returns of the benchmark ranged between 80% (2009) and –18% (2011). The attributions isolate the impact of active sector weights that naturally arise from smart beta strategies’ bottom-up portfolio construction and rebalancing processes. We also comment on the business characteristics and market valuations of specific holdings that demonstrate, for good or ill, the application of fundamentals-based selection and weighting principles. Over the five-year period, the Russell Fundamental EM Large Company had slightly higher volatility but outperformed the Russell EM Large Cap by approximately 20 bps.
Our findings suggest that, in emerging markets, the long-term performance of fundamentally weighted strategies is largely due to the contra-trading which takes place in the course of systematically rebalancing the stocks they contain. This observation is consistent with the results of empirical research we have conducted in other equity markets.
Portfolio Construction Affects Relative Returns
The Russell Fundamental Index series uses three measures of company size to select and weight portfolio holdings. They are sales adjusted for leverage, dividends and buybacks, and retained operating cash flow. Each measure is averaged over five years, and the resulting values are normalized and averaged to determine portfolio allocations that reflect the companies’ economic scale. The larger a company’s share of the economy, the larger its fraction of a fundamentally weighted index. Company weights are recalculated annually and implemented in quarterly steps. This staggered approach reduces market impact and spreads entry point risk across four dates spaced equally over the year.
By design, these company weights change little from year to year. (The five-year averaging ensures that each metric changes slowly over time.) Consequently, the turnover required at rebalancing primarily results from the prior year’s price drift. Companies whose stock prices advanced more than the broad market over the preceding 12 months see their allocation decrease when portfolio holdings are rebalanced to fundamental weights. Companies whose shares lagged the market see their weight increase.
This method of constructing and rebalancing the portfolio naturally creates a value bias in the Russell Fundamental Index strategies. Relative to a cap-weighted benchmark, the portfolio overweights cheap stocks and underweights expensive ones. Accordingly, when expensive stocks outperform the market, or their prices continue to trend away from their long-term average, the fundamentally weighted strategy underperforms the benchmark. When cheap stocks outperform, the strategy outperforms.
Returns in Emerging Markets
The Russell Fundamental Index series was launched on February 24, 2011, and March 2011 is the first full month for which actual rates of return were calculated. Hypothetical returns, however, have been calculated for periods beginning August 1996. The annualized return of the fundamentally weighted emerging markets large company portfolio from the start of the simulation through December 2013 was 13.3%, compared with 7.2% for the Russell EM Large Cap. The indices’ annualized volatilities were 25.4% and 25.1%, respectively. Thus, over a timespan longer than 17 years, the fundamentally weighted emerging markets index earned a return vastly exceeding that of the broad cap-weighted benchmark without a material increase in market risk. Value stocks outperformed the market over this measurement period; nonetheless, the annualized return of the fundamentally weighted index beat the Russell Emerging Markets (EM) Large Cap Value Index by approximately 260 bps. The volatility of the cap-weighted value index was 25.2%.
Figure 1 displays the year-by-year returns of the fundamentally weighted index and the broad emerging markets benchmark over the entire period for which data are available. We will analyze investment results for the five years ending December 31, 2013, in greater depth.