Research Affiliates (RAFI) has claimed global victory for fundamental indexing over market cap-weighted competitors after 15 years in the ring.
In a sequel to an earlier RAFI retrospective on the US markets, the ‘smart beta’ pioneer has published a new analysis this month showing its index-style based on fundamental company metrics has outperformed market cap-weighted international share benchmarks over the 15-year period to the end last year.
According to the paper, the RAFI global index returned an annualised 6.3 per cent over the 15 years to the end of 2022 versus 5.9 per cent for the cap-weighted benchmark (and 4.9 per cent for the broader value gauge).
The fundamental index outperformance came despite its strong value tilt during a period that generally favoured growth, the report says.
“As we observed in the US, value stocks all over the developed world underperformed horrifically from 2007 to 2020 (and in emerging markets from 2011 to 2020),” the analysis says. “But on the basis of their fundamentals—specifically their dividend distributions—portfolios of value companies did not. Investors expected the worst from value companies, and priced them accordingly, at ever-deeper discounts relative to the broad markets. But value indices soldiered on, delivering dividend growth roughly pari passu with the broad markets.”
RAFI, headed by Rob Arnott, developed the fundamental index in 2004, weighting and rebalancing stocks based on sales, cash flow, dividends, and book value to better reflect the “economic footprint” of underlying companies rather than market sentiment.
“Toyota and GE are vastly larger than Tesla and NVIDIA in economic terms, even if the market is happy to value the latter pair far more highly than the former. Cap-weighting reflects a market-centric worldview; RAFI reflects an economy-centric worldview,” the study says. “From a market-centric worldview, RAFI is nothing more than a cleverly constructed value index that happens to soundly and reliably outpace CW [cap-weighted] Value. From an economy-centric worldview, the CW broad market portfolio is nothing more than a cleverly constructed momentum-chasing, popularity-weighted growth strategy.”
The RAFI report says much of the fundamental index outperformance is due to “rebalancing alpha”, or contrarian trades designed to capture mean-reverting moves against big market consensus positions.
Consulting firm Watson Wyatt (now known as WTW, for Willis Towers Watson) dubbed RAFI and other “valuation indifferent” strategies as ‘smart beta’ in 2007.
“That term has fallen out of favor, arguably because it was embraced by much of the asset management industry, including the factor investing community, and attached to a whole array of strategies that lacked that essential rebalancing alpha,” the paper says. “As the term was applied to a host of ideas, both smart and dumb, with no common denominator other than their formulaic construction, it lost its relevance.”