Critics have lamented that the Fundamental Index™ concept is nothing more than a repackaged version of value and small-cap investing. Start with a broadly diversified equity portfolio, boil down the weighting of high-priced growth stocks, add a few quarts of low P/E shares, sprinkle some small caps to taste, and voilá, the Fundamental Index strategy is ready for mass consumption! Be careful, the critics contend, for this stew will leave the investor with a nasty case of heartburn once the small-cap and value stock party comes to an end. Before Fundamental Index investors rush to their Rolaids®, a further dissection of our recipe is probably in order.
Recall that the Research Affiliates Fundamental Index (RAFI™) methodology simply weights stocks in proportion to their economic size as measured by a combination of sales, dividends paid, book value, and cash flow. Conversely, cap-weighted indexes use one metric – capitalization – to determine a stock’s weight. The different approaches to selecting stocks for their respective indexes are illustrated in Figure 1.
The top 700 or 800 names within the top 1,000 will be virtually identical between the cap-weighted Russell and the fundamentally weighted RAFI (though, by construction, their weights will differ). However, as we move into the bottom range of the Russell 1000 we begin to encounter companies that are small on an economic scale (cash flow, sales, etc.) trading at lofty enough multiples to make the top 1000 by capitalization. When ranked based on the fundamental measures of size, these companies fall into the RAFI 1500. Similarly, near the top of the Russell 2000 we encounter companies that are large on an economic scale trading at somewhat depressed multiples. In a fundamental framework, these companies move up to the RAFI 1000, replacing the larger-cap small companies in rankings.
This exchange lowers the valuation multiples and market capitalization of the RAFI 1000. Conversely, the RAFI 1500 valuation multiples and size profile are boosted. Accordingly, the RAFI 1500 has a minimal value tilt (and occasionally a growth tilt) relative to the Russell 2000, and typically has a large-cap tilt!
If RAFI 1500 has a negligible value bias and a larger-cap tilt, efficient market proponents would claim it should underperform the smaller Russell 2000 over a long period. Are they right? Not even close! Since its inception in February 1990, RAFI 1500 has outperformed the Russell 2000 by approximately 4.6% per annum with less volatility. This is an even wider delta than the 2.1% advantage RAFI 1000 has historically shown in large companies. We have found similar results internationally. Furthermore, RAFI™ 1500 also exceeded the Russell 2000 Value Index over the same timeframe – by 1.9% annually. Recent short-term markets also prove that RAFI 1500 isn’t solely reliant on the value premium – through March 31, 2007, year-to-date returns showed the Russell 2000 Growth beating the Russell 2000 Value by 1.0% while RAFI 1500 exceeded the Russell 2000 by 1.2%.
The long-run outperformance of value and small company stocks is well documented. However, we believe the results of our small company example undermine the argument that value and small-cap tilts are the sole reason for Fundamental Index outperformance.
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