In response to the recurring underperformance of value stocks over the last several years, RAFI-based strategies, relying on a disciplined rebalancing approach, have increased their active weight to the two worst performing developed-market sectors—energy and basic materials—the only two sectors to post negative returns. In 2013, after rebalancing, the active weight to these two sectors for the FTSE RAFI Developed 1000 Index was 2.29%, in 2014 the active weight rose to 3.60%, and in 2015 to 5.59%.
What Winter Looks Like
As if there is doubt in anyone’s mind, let us state unambiguously that we are writing this particular missive from the depths of a very painful winter in value-land. Table 1 shows this clearly. On a 1-, 3-, 5-, and 10-year trailing basis, Russell 1000 Value generated solidly negative excess returns, −4.74%, −1.93%, −1.17%, and −1.25%, respectively. In a parallel, though much milder manner, FTSE RAFI US 1000 posted negative excess returns on a 1-, 3-, and 5-year trailing basis. Last year’s performance was very painful indeed at −3.42%, which dragged down the trailing 3- and 5-year excess returns to near zero.
The long-term tracking error (1962–2015) of FTSE RAFI US 1000 relative to the S&P 500 Index was 4.2% annualised,4 not exactly an “extreme” concentrated deep-value strategy. And yet, pronounced cyclicality is a reality. In the warmest of summers, FTSE RAFI US 1000 may outperform by 20% or greater, as it did in the aftermath of the tech bubble or after the darkest hours of the global financial crisis. Nonetheless, even a 4.2% tracking error allows for deep pain, as exemplified by the negative return posted in 2015.
We must remember, however, that seasons come and seasons go. Eventually long winter nights will give way to seemingly endless summer days in which we can enjoy the ripened fruits of seeds planted much earlier. Our notes then will be sun-filled postcards reporting stupendous excess returns. But summer weeks, like their preceding wintry months, succumb to the passage of time—and anchoring on their lost splendour only makes the next winter that much more difficult to tolerate.
Global Winter—Not Just the Northern Hemisphere
The same performance pattern for value relative to cap-weighted indices realised over the last decade in the United States also holds for similar strategies beyond the United States. In the long term, RAFI-based international strategies produced meaningful value-add, outpacing cap-weighted benchmarks by 1.94% (developed equities), 2.35% (developed equities ex U.S.), and 3.43% (emerging markets), as reported in Table 2. Shorter-term horizons, however, reveal a different story.