Pre-2005, an investor allocating any amount of assets to equities faced a binary choice: invest actively or passively. Active managers argued that prices deviate wildly from fair value. Passive managers countered this with a large amount of empirical evidence supporting the superior performance of index funds. Neither side was wrong. Nevertheless, a viable low-cost solution that fixed the return drag from cap weighting while retaining many of the benefits associated with indexing, such as capacity, economic representation, and ease of governance, did not exist. The RAFI Fundamental Index approach sought to solve this conundrum in a simple and intuitive manner by weighting the index using a gauge other than price. Arnott, Hsu, and Moore (2005) proposed using measures of economic size, such as sales, cash flow, book value, and dividends paid, and then rebalancing once a year. They showed how this and other non-cap-weighted indices plugged the “2% leak” in the cap-weighted boat by breaking the link between price and portfolio weight.
The intuition behind breaking the link between price and weight is clear given the inherent flaws of traditional market capitalization–weighted indices. A company’s market cap is the prevailing price of its stock multiplied by the number of its shares outstanding. As a company’s stock price goes up or the company issues more shares, the portfolio will hold a larger exposure to the company. If a stock’s price rises relatively more than the fundamental value of the company, the result can be a portfolio that holds relatively more overvalued stocks than undervalued stocks. Investor behavior often creates an increase in price volatility thus driving the gap between price and fundamentals further apart and increasing concentration risk at the sector, country, and/or stock level.
In contrast, a fundamental weighting approach uses measures of company size—namely, sales, cash flow, dividends paid, and book value—to sever the link between price (market capitalization) and portfolio weight. It then methodically contra-trades when prices deviate from fundamentals, selling when stock prices have rallied and buying when they are cheap and out of favor. A rebalancing premium is generated from systematically buying low and selling high.
The premise of the Fundamental Index methodology is that markets are not efficient and mean revert over time. This approach to index construction essentially creates a disciplined buy-low, sell-high investment strategy that active managers have been using for decades, but does so in a transparent, rules-based, high-capacity, high-liquidity, low-turnover, and low-cost index construct. The methodology was originally presented in the article "Fundamental Indexation" by Arnott, Hsu, and Moore (2005). Their findings showed the methodology produced an excess annual return of 2% over market capitalization–weighted indices. The RAFI fundamental weights act as stable rebalancing anchors, so that the index systematically rebalances into stocks that have fallen in price and rebalances out of stocks that have become expensive. A rebalancing premium is captured through trading counter to trend, or performance, chasers by buying securities that have performed poorly and are thus newly cheap, and by purchasing securities that have done well and are thus newly expensive.
While not a direct value strategy, the fundamental weighting approach does have links to value investing, which is one of the most popular if not the most popular investment anomalies. According to Benjamin Graham’s definition of value investing, Research Affiliates’ strategies would fall under the value-investing umbrella and thus are supported by much of the applicable investment theory. Investors have known about the benefits of value investing for nearly a century, but the approach was not popularized until Graham and Dodd published Security Analysis in 1934. More recently, the legendary investor Warren Buffet has preached the importance of long-term value investing. The value premium has also been documented by Basu (1977) and Fama and French (1992).
For a complete description of the Fundamental Index construction methodology, please refer to the rulebook, which can be found here.
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