Little has sparked as much debate in the past year as the FTSE RAFI indexes.  Indeed they attach the very foundations of efficient markets theory.  And now the first of these indexes can be bought in the form of an ETF. 

The FTSE RAFI US 1000 Index was selected by PowerShares Capital Management as the underlying benchmark for the exchange-traded fund.  The fund will be known as the FTSE RAFI US 1000 Powershares (PRF).  It is expected that PowerShares will launch an entire suite of FTSE RAFI PowerShares in the coming year to cover a wide array of asset classes with the distinctive FTSE RAFI methodology.

The FTSE RAFI indices are the brainchild of Rob Arnott, editor of the Financial Analysts Journal CEO of Research Affiliates LLC.  Arnott's paper, which highlights the research that is the basis for the indexes can be viewed here.   The PowerShares FTSE RAFI US 1000 Portfolio will track the performance of the top 1000 US-based companies whose fundamental factors - sales, cash flow, book value and dividends - determine the inclusion and weighting in the index.

According to Arnott's analysis, the FTSE RAFI 1000 Index Series shows a positive return of 34% over a five year period, compared to -8% from the S&P 500 and -4% from the FTSE US All Cap index over the same period. Arnott has historically showed that indices across all asset classes have showed outperformance of their cap-weighted counterparts, generally in the neighborhood of 200 basis points (2 percent) a year.  

Which Market?  

The "buy the market" philosophy is under attack from four sides, each using a different methodology to tweak traditional index exposure.  A recent NY Times article surveys the landscape of "enhanced" or "active" index products.

One of the most heavily publicized attacks comes from a group who believes that traditional indexes simply track the wrong market. Rob Arnott's group, Research Associates, launched a suite of new indexes on November 28 called "Fundamental Indexes".  Developed with FTSE, these indexes reject the traditional way of weighting stocks within an index - using market capitalization - in favor of a "fundamental approach."

It's not really a new idea.  We've come to accept market capitalization weighting as the "correct" way to index, but that hasn't always been the case. The first index - the Dow Jones Industrial Average - was (and is) weighted by the price of the shares within the index. Other popular indexes weight each stock equally. Indeed, the world's first index fund, launched by Wells Fargo for Samsonite Corporation, was equally weighted.  And both inside and outside the index industry, investors have long been looking for ways

Arnott's innovation is to weight companies according to a set of "fundamental measures" - sales, cash flow, book price and dividends.  If that sounds like the kind of screen that some active managers apply to stocks, it's not a mistake - Arnott's group believes these four traits correlate with good returns.

These indexes are attracting a lot of attention - they won the IMN/IndexUniverse.com award for "Most Innovative Index" in 2005.

"By definition, (in a market cap index) overvalued stocks will have extra weight in the index at the expense of undervalued companies," explained Jason Hsu and Carmen Campollo, Arnott's collaborators, in a recent article in the Journal of Indexes.  "A passive index investor is forced to allocate more of his portfolio in overvalued stocks and less of his portfolio in undervalued stocks - exactly the opposite of what common sense investing would suggest." (Jason Hsu and Carmen Campollo, New Frontiers in Index Investing, Journal of Indexes, Jan/Feb 2006.)

According to Arnott's analysis, the FTSE/RAFI 1000 has delivered two percent extra return relative to the S&P 500 on an annual basis; international indexes have done even better.  A number of index industry experts have claimed that they have been unable to duplicate Arnott's results, and attack the data as back-tested and possibly even inaccurate.  If this is so, we can expect intensive reviews of the data as more products are launched.  In any event, the proof will be in the pudding.  And the pudding, in this case is "future returns".

But before you get too excited, take a look at this chart (from JoI) stretching back into the 1960s.  The US RAFI 1000 does not really begin to outperform until the very tail end of the Internet bubble.  . That covers a unique period when the market underwent a huge correction - primarily to large cap, growth-oriented technology stocks.  It certainly pays to avoid these bubbles - but then again, they may not come along again for a long time. The 1990 bubble period, though extraordinary in its strength, is reflective of the strong history of outperformance that Arnott has demonstrated.  Investors reap huge benefits in particular when markets become heavily overvalued at the top of the capitalization range.

The idea behind market cap weighting is that the market, with its collective intelligence, chooses how to value companies.  The RAFI indexes, in contrast, claim that they know best; that they've identified the four variables that really matter.  That's a pretty strong statement. 

The back-tested data for these indexes is strong, and the philosophy makes inherent sense.  But given that the bulk of the outperformance came during one of the most violent market corrections in history, questions remains.  The performance of the ETF will be the true test.