EQUITIES
BONDS
Is the RAFI strategy really an "index?"
The answer depends entirely on how one defines an “index.” From the perspective of the Capital Asset Pricing Model—the seminal work that relates the price of each security to the market as a whole—anything that’s not cap-weighted is neither passive nor is it an index. By this definition, a Fundamental Index strategy is neither passive nor an index. If, alternatively, we define an index as something which is formulaic, objective, transparent, historically replicable and low-turnover, a Fundamental Index strategy qualifies on all counts. Ironically, many of the cap-weighted “indexes” don’t qualify for this simple pragmatic definition of an “index.”
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Does the RAFI
strategy have a bias toward value and smaller cap stocks?
RAFI strategies weight companies by their economic footprint. Accordingly, it is neutral relative to the composition and weightings of business enterprises in the economy. Cap-weighting, in contrast, has a stark growth tilt—companies at twice the market multiple get double their economic weight, while companies at half the market multiple get half their economic weight.
For example, in 1997, Cisco Systems was 0.4% of the market at 30 times earnings. By the end of 1999, it was 4% of the market at 130 times earnings. Did it comprise 10 times as much of the market at the peak of the bubble because it was 10 times as attractive (with a price-to-earnings ratio more than four times as large as in 1997)? Of course not. The weighting went up 10-fold because the stock went up 10-fold relative to the average stock, and because it was now at 130 times earnings. A Fundamental Index strategy does not get drawn into this sort of bubble.
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What happens when value
and small-cap are out of favor?
When growth and value have similar returns, the Fundamental Index strategy wins. Why? Because it will not fall prey to overweighting overvalued companies and underweighting undervalued companies relative to their unknowable future prospects and true fair value. When value is winning, the RAFI strategy has a tailwind and adds even more value. When growth is winning, the RAFI strategy’s added value goes down and, in a strong growth market, can easily go negative.
Fortunately, we can have some confidence that momentum-driven growth markets do not go on forever and that, by the time they are over, the RAFI strategy will have such a strong value tilt that it will benefit handsomely from the return to value. The Fundamental Index strategy’s contra-trades against whichever style is in vogue.
See the August 2007 and July 2010 issues of Fundamentals for a description of the dynamic nature of the RAFI value and size tilts.
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How does
the RAFI portfolio compare with an equal-weighted portfolio?
An equal-weighted portfolio, such as the S&P 500 Equal Weight Index, breaks the link between price and index weight and, thus, theoretically performs very well relative to a cap-weighted index. Unfortunately, equal-weighted portfolios have practical limitations that make them unattractive as investments. In particular, equal weighting fails to reflect the real economy, some stocks lack capacity for large-scale investments, and turnover costs are relatively high in such portfolios. See the July 2007 issue of Fundamentals.
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Who calculates the equity index?
FTSE, a global leading index provider, calculates the FTSE RAFI Index Series. For more information about FTSE and the series, please visit FTSE’s website. Research Affiliates also is developing an equity index series with Russell Indexes, a unit of Russell Investments, a pioneer in index construction. For more information about Russell Indexes, please see their website.
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Why does the RAFI methodology work with bonds?
The same return drag that affects cap-weighted equity indices also applies to fixed income. In addition, traditional bond indices give their greatest weights to the biggest debtors. Should investors buy more of a company or nation’s debt solely because it increases its issuance? Intuitively, fundamental measures of company or country size offer advantages over market-weighted fixed income indexes. Sales, cash flow, book value of assets, and dividends represent metrics that can impact an issuer’s ability to repay debt.
As with equity portfolios, the amount of outperformance increases in noisier bond markets. Our research, published in the Journal of Porfolio Management, shows that the Fundamental Index methodology applied to high-yield corporate bonds outperformed a cap-weighted benchmark by 260 bps per year; applied to investment-grade corporate bonds surpassed the relevant Merrill Lynch benchmark by 42 bps per year; and applied to emerging-market bonds beat a market-cap-weighted index by 143 bps per year. The time period measured was January 1997 through December 2009.
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Does the strategy make duration or credit bets?
RAFI fixed income strategies are not designed to make either credit or duration bets. However, RAFI corporate bond strategies will tend to have higher credit ratings than their market-weighted counterparts. By basing issuers’ weights on the fundamental factors, RAFI strategies are explicitly weighting issuers by variables that impact issuers’ ability to repay debt. If all else is equal, a firm with relatively high cash flow will be better equipped to repay a given level of debt than a firm with relatively low cash flow. In contrast, traditional bond indices weight issuers solely by the market value of each firm’s outstanding debt with no regard to underlying firm fundamentals.
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Are there parts of the economic cycle where the strategy underperforms the cap-weighted index?
In looking at the performance of RAFI corporate fixed income during different economic cycles, we examined performance during bull and bear markets and during periods of rising and falling interest rates. While RAFI bonds did not underperform during any of the periods, outperformance was far more pronounced during bear markets and periods of falling interest rates. Outperformance during these periods of market distress is most likely attributable to the quality bias of the RAFI strategies in relation to their cap-weighted counterparts.
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Who calculates the RAFI bond index?
Ryan ALM, Inc., an asset and liability management firm calculates the RAFI U.S. corporate bond indexes. The firm was founded by Ron Ryan, CFA, a pioneer in bond and liability benchmark design. For more information about Ryan ALM, please visit their website.
The index is available for licensing from Research Affiliates. The ticker symbol for the U.S. corporate high-yield bond index is RAFIHY.
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