The Great Contra-Trade

By Rob Arnott

MAY 2009 Read Time: 10 min

At its heart, rebalancing is a simple contrarian strategy. In ebullient times, this means taking money away from our biggest winners. In the worst of times, the process forces us to buy more of the assets that have caused us the greatest pain. Most investors acknowledge it as a critical part of the successful investor’s toolkit. But recognition and action are two different things. Surrounded by bad news, pulling the trigger to buy securities down 50%, 75%, or even 90% is exceedingly difficult for even the staunchest of rebalancers. Many lose their nerve and blink, letting a healthy portion of the excess returns slip from their grasp.

Most investors focus some attention on rebalancing between asset classes, but not within asset classes. The Fundamental Index™ strategy affects this uncomfortable, yet profitable, exercise within the stock market. Anchoring on company financial size, it annually rebalances stocks that have experienced the greatest price movements relative to their fundamentals. The past 15 months have been a frightful period challenging the efficacy of global Fundamental Index applications as they gravitated toward some of the sectors and stocks most afflicted by the financial crisis. Although it took a while, contra-trading against the markets fears finally paid off in recent weeks with remarkable outperformance of global Fundamental Index applications.

As we lamented in January 2009, 2008 wasn’t much of a year for value investors, running contrary to most bear markets in which growth stocks lead the way downward. The beginning of 2009 was even worse with the Russell 1000 Value posting a –16.8% return, nearly 1,300 bps off of the Russell 1000 Growth’s –4.1% in the year’s first three months. It was the second worst relative quarter ever for the Russell 1000 Value, eclipsed only by the tech bubble induced fourth quarter of 1999. As value stocks were punished in the first quarter, their representation in the capitalization-weighted indexes shrank and shrank. The FTSE RAFI® series, meanwhile, conducted its annual rebalance at the end of March and bought whatever had decreased more in price than fundamental size. That translated into a huge purchase of financials, consumer discretionary stocks, and industrials, widening the overweights to these deep value sectors in many RAFI applications.1

Many observers credit the value tilt of RAFI strategies as the source of its long-term historical success. The reality is more subtle. The main source of value-added is not the average value tilt of the RAFI portfolios, but its dynamic contra-trading against the most extreme market bets. Value stocks got cheaper and cheaper and—as a direct consequence—our value tilt got larger and larger. These dynamic style tilts are primarily the result of contra-trading against the market’s constantly shifting expectations, fads, bubbles, and crashes.

Where did the huge rebalance into large companies at rock bottom prices lead us at the end of March? As shown in Table 1, virtually all RAFI strategies showed tremendous tilts toward value as measured by relative valuation multiples. The discounts in all areas (U.S. Large, U.S. Small, International Large, International Small, Emerging Markets, and All World) were the largest since the top of the bubble in 2000 for price/book, and the largest on record for price/sales. (The discounts on the dividend yield measures are more equivocal, because so many deep value companies have cut or eliminated their dividends.)

Unquestionably, the relative cheapness of the RAFI portfolio at the end of the first quarter was driven by large exposures to the unwanted and left-for-dead deep value companies. But any asset is attractive at some price. That price appears to have been reached near the end of March judging by recent performance. RAFI portfolios soared in April in absolute terms and especially relative to the cap-weighted alternatives. April was the best month ever for FTSE RAFI US 1000 relative to both the S&P 500 Index (9.33% excess return) and the Russell 1000 Value (8.18% excess return.) In fact, the U.S. large company segment was hardly alone as many FTSE RAFI portfolios had their best month ever as evidenced in Table 2. It’s shocking to note that this result was achieved merely by reweighting the deeply loathed segments of the market back up to their economic scale, based on long-term sales, profits, dividends and current book values. These indexes include the growth stocks, at their full economic weight, not just deep value.

After the stellar results of April, the performance of RAFI indexes is now at or ahead of capitalization weighting for the month, the year-to-date, and the past 12 months. Extending the comparison to three years, seven of the nine RAFI applications show value add. For those that claim the Fundamental Index strategy is repackaged, backtested value investing, the FTSE RAFI All World 3000 Index has achieved excess returns of 2.9% above the MSCI All Country World Index since the beginning of 2005, when our methodology was already established and about to be published.  But, it achieved an even larger 3.1% per annum excess return above the MSCI All Country World Value Index. Value underperformed over these 4 ¼ years, but RAFI portfolios prevailed handsomely and globally.

It feels like something of a vindication for an idea that was drawing increasing heat.2 How did a concept go from goat to hero so fast? By simply following its annual rebalance of each stock to the company’s long-term fundamental scale in the economy, the RAFI strategy automatically contra-traded against the greatest fear driven market of our lifetimes. On the flip side, what did the cap-weighted indexes reflect? Because their weights drift with price, they had next to nothing remaining in the left-for-dead financials and cyclicals that led the recent market rally.

Rebalancing isn’t always a profitable activity. Ask any fiduciary that rebalanced away from stocks in the 1980s and 1990s or into stocks during the two extended bear markets of this decade. But it does pay off over longer periods. The same goes for rebalancing, for contra-trading, within the equity markets. What we’ve lacked in the past was a sensible anchor for rebalancing within the stock market. Equal weighting worked—the S&P Equally Weighted Index (SPEWI) has beat the S&P 500 consisting of the self-same companies by over 1.6% per year since the SPEWI was launched in 1990. But, equal weighting has no economically meaningful foundation for the chosen weight. The RAFI strategy uses the fundamental economic footprint that a company occupies within the broad economy as an anchor for rebalancing. That is, its main profit engine, not its preference for value stocks per se.          

Racing to short-term conclusions, whether pro (April 2009) or con (2008 and first quarter 2009), on a long-term strategy is foolish. Frightful times require rigorous discipline and the long view, both of which are inherent in the Fundamental Index concept.

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1. As an example, the FTSE RAFI US 1000 added 10% to financials, 2% to industrials, and 1% to consumer discretionary while subtracting from defensive sectors like consumer staples (–4%), health care (–4%), and utilities (–3%).
2. Evan Hessel, “Can You Out-Index The S&P,”April 27, 2009, Forbes