Regardless of whether it is labeled an index, an active strategy, or somewhere in the middle, the Fundamental Index™ portfolio is designed to excel in markets where prices deviate from fair value. As long as there is some probability that the market might be inefficient, complementing your capitalization-weighted portfolio with a Fundamental Index portfolio is a good hedging strategy.
Infrequent bubbles are a recurring theme in the history of investments. With certainty, it is not a question of if but when. Of course, we will never know the moment the next episode is upon us. It seems sensible to provide some protection in our index fund exposure for this eventuality by diversifying a portion of funds into a price indifferent approach. Even if the four most dangerous words in investing—it’s different this time—miraculously prove true, the portfolio would still be covered by the cap-weighted index fund allocation, which would steadily increase its weight in the hot market segment.
Active managers may not be a good hedge against the downside of bubbles. While firmly believing they should bypass the latest craze, some will succumb to the intense pressure to please their clients and keep their jobs by giving in to the conventional bubble wisdom. Agency conflicts contribute to this type of behavior. For example, investment firms owned by parent organizations, particularly those that are publicly traded, are expected to keep revenues growing to meet shareholder demands.
The benefits of diversifying a portfolio’s indexed equity exposure can be seen clearly when one looks at the composition of the Fundamental Index portfolio, as measured by RAFI™ US Large Company, relative to the S&P 500 market portfolio during bubble periods. As Figure 1 shows, the Fundamental Index portfolio’s tracking error dramatically rises as it naturally rebalances the hot stocks back to their fundamental size while the cap-weighted index is magnifying its bet on the upside of the bubble. In each case, the RAFI portfolio went on to produce sizeable relative gains as the new paradigm theme failed to materialize, and the bubble burst.