Research Affiliates

RAFI Fundamental Index strategies are poised to outperform... Currently trading at low valuation levels, RAFI Fundamental Index strategies have a history of outperformance during periods of heightened inflation, bear markets, and recessions.

As we start 2023, the US dollar has pulled back 12% from its high in September 2022, but remains 25% elevated from its lows at the start of the last decade. The US dollar’s long march upward may be ending, squeezed by an expected shrinking interest rate differential with other developed nations that must keep hiking rates to fight inflation. The Fed, however, as US inflation appears to moderate, can also moderate its rate hikes. Our research shows that in a weakening dollar environment, unhedged foreign stocks and bonds should outperform.

Five years after the publication of our controversial 2016 paper “How Can ‘Smart Beta’ Go Horribly Wrong?” we analyze how the factors did perform from June 2017 through June 2022. Most fell far short of expectations. Today, we are bullish for the mirror image of the reasons we were cautious in 2016 and 2017. Of the 19 factors we study, 11 are now trading in the cheapest quintile of their historical relative valuation. Now is a promising time to embrace multi-factor investing.

The common error of aggregating individual stocks’ earnings to the market reliably overstates aggregate future market earnings and understates the aggregate market P/E ratio. We analyze the impact this practice may have on earnings estimates for 2023.

Across 14 developed-economy countries over the last half-century, we analyze the behavior of inflation once a country’s inflation rate surges past various thresholds and study how long a burst of inflation typically lingers. If history is a guide, inflation can take far longer to return to normal levels than most people realize. “Transitory” inflation is certainly possible, but it is hardly a sensible central expectation. Messaging and policy response from the US Federal Reserve Bank should reflect the relatively high empirical risk that inflation may persist.

We demonstrate the benefits of an inflation cycle signal that dynamically tilts portfolio allocations during periods when inflation veers from expectations. The signal can be used in both rising and falling inflationary environments.

Although hidden risks of factor investing can lead to investor disappointment, a variety of techniques can improve the risk-adjusted returns of individual factors and factor portfolios. Specifically, a new two-step volatility management approach, coupled with an optimization technique that captures volatility and correlation information, leads to improved risk-adjusted performance, lower volatility of volatility, and improved kurtosis and drawdown characteristics. 

Value investing has underperformed growth investing for the last 13.5 years. The drawdown is the longest and deepest since 1963 and is explained by value becoming unusually cheap relative to growth. As of June 30, 2020, the relative valuation of the HML value factor fell to the 100th percentile of the historical distribution.

Factor investing has failed to live up to its many promises. Its success is compromised by three problems that are often underappreciated by investors. 

Unlike standard factors, such as value, momentum, and size, “quality” lacks a commonly accepted definition. Practitioners, however, are increasingly gravitating to this style factor. 

Valuation, always an effective tool for long-term investors, can also be useful for assessing short-term market prospects. The authors demonstrate that conditioning CAPE on current inflation and real yields substantially improves its accuracy in forecasting returns for periods from one month to one year. 

Not every factor profits investors when implemented through a passive strategy. Size and quality show weak robustness, and liquidity-demanding factors, such as illiquidity and momentum, are associated with high trading costs.