RAFI Dynamic Multi-Factor is designed to have more evenly dispersed loadings on the value, low volatility, quality, momentum, and size factors. The more balanced exposures to factors beyond value imply a low correlation between the two strategies and a lower tracking error versus the cap-weighted benchmark for RAFI Dynamic Multi-Factor. Correlation of excess returns between the two index strategies throughout history is only 42%.9
In the context of investor preferences, the difference in factor exposures provides investors with an interesting choice. RAFI makes large uncomfortable bets when value is trading cheaply. For example, at the height of the tech bubble, RAFI’s three-year annualized tracking error versus the market was approximately 11%, largely stemming from an underweight to technology of 18.7%. Similarly, during the global financial crisis in 2008, tracking error was approximately 4.5%,10 driven by a total overweight of 6.5% to the battered consumer cyclical and financial sectors. Certainly holding these positions was uncomfortable at the time, but investors in the strategy were ultimately rewarded when the market reverted to the mean and value paid off. A patient investor with a conviction in the benefits of contrarian investing would have been comfortable with these interim deviations from the benchmark. The majority of investors, however, followed the crowd and loaded up on technology stocks in the late 1990s as the tech bubble expanded, and sold out of financials in early 2009 as the financial crisis bottomed out.
Investors who are uncomfortable with contrarian positions should find greater comfort with a strategy that offers more balanced factor exposures and lower tracking error, and thus should find it easier to stay the course. The RAFI Dynamic Multi-Factor US Index appears to fit the bill. During the tech bubble, the strategy registered a tracking error of approximately 6.5%, almost half that of the RAFI US Index, while having a much more modest underweight (6.0%) to technology. Its tracking error was a mere 3.2% in the midst of the global financial crisis, while being underweight consumer cyclicals and financials by approximately 0.5%.