The RAFI™ strategy performed brilliantly in 2005 and 2006. So what? Value beat growth in those years, so we had a tailwind. As Gus Sauter suggested in 2005, the real test is how it does when growth beats value. By all measures, 2007 was a strong growth-dominated market. So, how did the RAFI approach perform in what should be a hostile environment for a value-oriented strategy? Actually, quite well. Indeed, startlingly better than classic value strategies and even far better than most quantitative enhanced index strategies.
Despite the well-known RAFI value tilt relative to the cap-weighted market, we find surprisingly strong performance—even some positive excess returns—for Fundamental Index™ strategies. We also find an asymmetry in RAFI returns that should cause those who dismiss the concept as nothing more than a simple value-biased approach to give the concept a second look. In this special edition of RAFI Fundamentals, we mark the three-year anniversary of the very first live portfolio based upon the Research Affiliates Fundamental Index (RAFI) by revisiting Fundamental Index performance in light of the stark value and growth markets of 2006 and 2007, respectively.
From the outset, we have always acknowledged that a Fundamental Index construct would typically have more exposure to value-oriented stocks than similar cap-weighted indexes. To understand this dynamic, imagine two stocks with identical sales, book values, cash flow, and dividends. The first stock, Growthy Shares Inc., trades at twice the market multiple because of high future growth expectations. Meanwhile, Distressed Co., with its comparatively bleak outlook, sells at half the market multiple. Cap weighting doubles the weight of Growthy and halves the weight in Distressed, thus ensuring a growth bias relative to today’s economy. Because the market prices companies to reflect expectations for the future economy, it prepays for Growthy’s anticipated future success (and pre-discounts for Distressed’s expected weakness), so that 80% of our portfolio is invested in Growthy. Meanwhile, the Fundamental Index strategy, ignoring future expectations and reflecting today’s economy, gives the same weight to each company. When viewed through the lens of cap weighting, this gives the Fundamental Index methodology a value orientation.
The outperformance of value stocks over long stretches is well documented. Widely used market proxies confirm this value premium—the Russell 1000 Value Index has exceeded the S&P 500 Index by 90 basis points since 1979. However, this annual premium is not linear; growth stocks have experienced tremendous bursts of outperformance during the period. 2007 proved to be just such a year. In fact, it was the fifth best calendar year of growth performance in large-cap U.S. stocks since the inception of the Russell 1000 Growth and Value Indexes in 1979. As Figure 1 shows, growth stocks trounced their value counterparts by at least 1,000 basis points in U.S. Large Company, U.S. Small Company, and International equities.
Figure 1. 2007 Performance