Both the RAFI Dynamic Multi-Factor Index and RAFI Multi-Factor Index series are broadly diversified across five factors: value, low volatility, quality, momentum, and size. While each index provides relatively lower tracking error and potentially less volatility than single-factor strategies, the index will underperform in certain market environments. Periods of strong market performance or environments in which a couple of factors underperform significantly will pose headwinds for the strategy.
United States
The chart below plots the rolling one-year excess returns of the RAFI Dynamic Multi-Factor US Index compared to the Russell 3000 Index.
There are four periods of notable underperformance for both the Dynamic Multi-Factor Index and the Multi-Factor Index: the late 1990s, 2003, the late 2000s, and mid-2017. The late 1990s (the tech bubble) was characterized by strong market performance in which four (value, low volatility, quality, and size) of the five single-factor strategies significantly underperformed the market. These four strategies have one thing in common: they all contain an element of contrarian rebalancing because they are fundamentally weighted, after selection by desired characteristic. Any strategy that systematically rebalanced during this period suffered.
In the period from October 2002 through September 2003, the index underperformed the benchmark by approximately 7.0%. This was a period of strong market performance, with the Russell 3000 Index up ~25.0%. Three of the five factors underperformed the market during this 12-month period: low volatility by 14.0%, quality by 6.5%, and momentum by 12.2%. Value and size were actually the largest allocations to the dynamic index at this time (21.2% for value and 24.2% for momentum), however, the significant underperformance of the other three single-factor strategies overpowered these two factors’ strong showing.
The global financial crisis in the late 2000s was a third period of underperformance for the RAFI Dynamic Multi-Factor US Index. During the 12-month period ending February 2010, the RAFI Dynamic Multi-Factor Index underperformed versus the Russell 3000 Index by 3.95% and the Dynamic Multi-Factor Index underperformed by 2.40%. Although both indices performed well during the run up to the global financial crisis, when the market rebounded off its September 2009 low, the single-factor strategies did not keep pace with the market’s strength.
The most recent period of underperformance occurred in mid-2017 for reasons similar to those seen during the tech bubble in the late 1990s. During the second and third quarters of 2017, momentum was the only factor to outperform the market. In the Dynamic Multi-Factor Index, the allocation to momentum was highest during the second and third quarters (23.92% and 27.00% respectively) but not high enough to compensate for the underperformance of the other factors.
Developed Markets
The chart below plots the rolling one-year excess returns of the RAFI Dynamic Multi-Factor Index and the RAFI Multi-Factor Index compares to the MSCI World Index.
Similar to the US market, both the Developed Dynamic Multi-Factor Index and the Developed Multi-Factor Index experienced drawdowns during the tech bubble in the late 1990s, the late 2000s, and mid-2017. Developed markets also experienced a drawdown in late 2003, albeit to a lesser extent. The reason for the underperformance is consistent with the explanation above.
Emerging Markets
The chart below plots the rolling one-year excess returns of the RAFI Dynamic Multi-Factor Index and the RAFI Multi-Factor Index compared to the MSCI Emerging Markets Index.
Similar to Developed and US markets, both the Dynamic Multi-Factor Index and the Multi-Factor Index experienced significant drawdowns during the end of 2009 and mid 2017 in the Emerging Markets region. The reason for the underperformance is consistent with the explanation above.
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