In Marcel Duchamp’s famous 1912 painting, Nude Descending a Staircase, No. 2, the French painter captured the sense of motion by illustrating a series of images—all displayed in one frame.1 The controversial painting was inspired by Cubism’s breakdown of familiar images into multiple perspectives. But it went one better than the Cubists—who typically used static images—by adding motion, reflecting the influence of the nascent motion picture industry.2 The painting forced the observer to rethink how he or she viewed art.
Similarly, the Fundamental Index™ methodology forces investors to rethink how they view portfolio returns. Investors typically dissect returns, trying to understand how much of performance is attributable to sector bets and how much to stock selection. Like Cubists, they are deconstructing reality and then putting it back together. But what if we—like Duchamp—add motion to the picture?
We are commonly asked why the Fundamental Index methodology overweights and underweights certain sectors. What’s the rationale? Why does the strategy “like” this sector or that sector? In recent years,
the methodology has overweighted financials and underweighted energy, leading a rational person to conclude that holding such wrong weights surely caused performance problems. In this issue, we show such structural sector bets, in fact, don’t matter over the long term. Indeed, the Fundamental Index strategy can be wrong on average but right in the long run because of its ability to contra-trade against market fads, crashes, bubbles, and speculation. Investors need to look at the movement embodied in such strategies—not just their average holdings over a period in time.
Contra-Trading—The Great Equalizer
The markets have been through an extraordinarily volatile period the past five years, beginning with strong equity returns in 2006–2007, followed by the Global Financial Crisis (GFC) in 2008, and the subsequent Mother of All Recovery rallies in 2009–2010. Talk about a full market cycle! Within this period, sector returns have varied widely as evidenced in Figure 1.
During this period, energy and financial stocks have experienced dichotomous lives. Energy stocks jumped 10% per year and led all sectors of the market. Meanwhile, the GFC pounded financial stocks. To be fair, some financial institutions caused the GFC and were punished accordingly with the sector losing over 10% per annum. Indeed, financial stocks were the only sector to actually lose money and the only sector to underperform the S&P 500 Index during this time span. The other nine sectors all outperformed the broad market.
The FTSE RAFI® US 1000 held an average weighting of 24% in financials since it went live in November 2005, compared with the S&P 500’s average weighting of 18%. In other words, the Fundamental Index concept held an average overweight of 6%. Uh-oh. At one point in this cycle, financials registered the worst performing one-year period for any sector going back to 1989,3 even worse than technology stocks after the collapse of the TMT bubble. With the RAFI™ strategy’s sizable overweight to the lone absolute and relative loser of the last five years, a logical expectation would be a big shortfall in RAFI’s performance relative to cap-weighting. In reality, the FTSE RAFI US 1000 beat the S&P by 2.3% per year, similar to the excess return as published in the original research!4
This counterintuitive result provides a good example of how the Fundamental Index concept adds value through the contra-trading embedded into the annual rebalance back to fundamental weights—that is, back to the economic footprint of the constituent companies. Figure 2 shows the FTSE RAFI US 1000’s relative financial weights (in other words, the active sector bet versus the S&P 500). Financials had a slight overweight in the FTSE RAFI US 1000 until the March 2008 rebalance, when the strategy took on an 8% overweight after bank share prices began to fall in summer 2007. In March 2009—six months after Lehman Brothers Holdings’ spectacular collapse and changes that forever changed the face of the financial services industry—financials were again rebalanced back to their fundamental weights of 25% (versus 11% for the S&P). Then the sector—left for dead in early 2009—took off. The financials weight of the FTSE RAFI US 1000 reached almost 20% more than the respective S&P 500 weight in fall 2009. As bank prices rebounded strongly, the March 2010 rebalancing witnessed a trimming of financial weights back to their fundamental scale. All told, the RAFI strategy made profits in spite of a large overweight in a sector that would have lost half its value if the weight had not been adjusted from March 2006.