What’s this worth? In the United States, the Fundamental Index approach produces an excess annualized return of 220 bps, equivalent to 43% of the perfect style roulette strategy, for the 1979–2009 period studied (see Table 2). This result is nearly half of a clairvoyant, and unattainable, style timer! Not bad, but look at what happens to the non-U.S., global, and emerging markets strategies. Remarkably, the RAFI methodology captures more than 100% of a perfect style timing strategy! Of course, there is more to the Fundamental Index methodology than systematic contra-trading between styles; dynamic exposures to size (small versus large), economic sectors, countries and regions also are additive to portfolio returns.
The intuition behind why the Fundamental Index approach is so successful is simple. Remember what happens in the cap-weighted index when one style outperforms meaningfully—it comprises more of the index! Thus, when growth was taking off globally in the late 1990s, the weights for the tech and telecom winners increased in the cap-weighted index. The comparable weights in a Fundamental Index portfolio, paying no attention to rising valuations, were pared back at the annual rebalance point to be in line with each company’s fundamental size. The resulting Fundamental Index portfolio looked more and more like a deep value index (note the yellow line briefly goes above “1” during this time period).
Meanwhile, when value goes on an extended winning streak (as seen in the early 1990s and mid-2000s), the Fundamental Index portfolio lightens its value orientation. How? The same way it extended it in the late 1990s— it trims its recent winners back to their fundamental size! (The yellow line troughs in the 0.2 range). The changing nature of the RAFI value exposure—resembling a deep value portfolio after strong growth runs and a mild value orientation after value outperformance—certainly appears to add value to portfolio returns when mean reversion occurs.
Legendary gambler Nick “the Greek” Dandalos once said: “Remember this: The house doesn’t beat the player. It just gives him the opportunity to beat himself.” The style merry-go-round similarly provides ample opportunity for investors to be their own worst enemy, even within the supposed balanced broad market indexes. Make no mistake—cap-weighted index funds are stealthy returns chasers loading up on past winners.
The Fundamental Index concept contra-trades against the market’s recent popularity contest winners. This approach clearly means that we sell whatever is newly most beloved and buy what is newly most loathed, which can hardly be easy or comfortable. This simple periodic realignment back to financial size remarkably captures over 100% of a perfect style timing strategy in three major non-U.S. equity asset classes. So, rather than play the roulette wheel at our own risk, we’ll take our chances at the rebalancing table.