1. For those unfamiliar with the strategy, RAFI simply selects and weights companies according to their macroeconomic scale, rather than their market capitalization. Much as conventional indexing assiduously tracks the look and composition of the stock market, RAFI assiduously tracks—and rebalances toward—the look and composition of the publicly traded macroeconomy. The three largest providers are FTSE RAFI and Russell RAFI (both offered by FTSE Russell) and our own RAFI Multi-Factor Index strategy, as well as other variants of the strategy. Arnott, Hsu, and Moore (2005) and Arnott, Hsu, and West (2008) provide a thorough explanation of the fundamental index strategy.
2. Towers Watson observed that other strategies, such as equal-weight, minimum-variance, and optimization-based, as long as they do not anchor on tracking error or sector weights relative to the cap-weighted market, can achieve the same contra-trading performance impact.
3. These calculations are based on the relative wealth of a RAFI investor versus the Russell 1000, assuming a start date of December 31, 1987.
4. We acknowledged RAFI’s stark value tilt from the beginning. We like the following thought experiment: Does RAFI have a value tilt, or does cap-weight have a growth tilt? Both are true. RAFI mirrors the look and composition of the macroeconomy, which is dominated by big value companies; the cap-weighted market is dominated by expensive growth companies, because they are presumed to eventually dominate the future economy. RAFI is value tilted relative to the market, and the market has a growth tilt relative to the macroeconomy.
5. At this writing, the FANG+ stocks has been defined to include the FANG stocks (Facebook/Meta, Amazon, Netflix, and Google), plus the winning survivors from the dot-com bubble (Apple, Advanced Micro Devices, and Microsoft), plus some of the newer frothy meme stocks (NVIDIA, Tesla, and Snowflake).
6. The CFA Institute awarded this article with the Graham and Dodd Scroll accolade in 2021.
7. The size of the rout is measured from new high-water marks in either Russell 1000 Value or RAFI relative to the Russell 1000 until Russell 1000 Value hits its trough relative to the Russell 1000. We use this approach because Russell 1000 Value had very few “new high-water marks” in relative performance against the market.
8. How is it that the Russell 1000’s dividend income growth exceeds that of the Russell value and growth indices? Value and growth indices have a subtle rebalancing nuance that can slightly erode (or boost) both portfolios’ dividend yields in some years relative to the broader Russell 1000. They rebalance in June each year. Imagine if growth beats the market by 20% and value lags by 20% from June of one year to June the next. The market will now be 60% growth/40% value. In addition to some companies coming into the Russell 1000, and some leaving, one-sixth of the growth stocks will be reassigned to value. This causes the dividend yields – hence income stream – for both the growth and value portfolios to drop materially, while the Russell 1000 experiences nothing of the sort. In fact, this is exactly what happened in June 2000 and again in June 2020.
9. Arnott and Chaves (2012) examined this phenomenon in their award-winning article, “Rebalancing and the Value Effect,” published in the Journal of Portfolio Management.
10. For research into this phenomenon, we refer you to Arnott, Li, and Sherrerd (2009a, 2009b).