The current credit shake-up began one year ago, with Bear Stearns revealing large losses incurred in its two subprime-heavy hedge funds. Since that time, RAFI^® equity applications have delivered mixed results with generally sound performance overseas—especially relative to the conventional capitalization-weighted value indexes—and shortfalls in the United States. In light of these mixed results, we examine the Fundamental Index^® approach in previous difficult credit and liquidity periods and explore some attribution of the recent shortfall in the United States. While recent times have been disappointing for some cases, this exploration suggests the Fundamental Index concept remains as valid as ever. Indeed, in most markets outside of the United States, RAFI has performed admirably in the face of a hurricane-force headwind—that is, growth sharply outpacing value.

Since the credit crunch started, growth stocks have ripped market leadership away from value in a startling fashion all over the world. Figure 1 displays the excess returns of value over growth across five major equity categories. Only emerging markets witnessed value outperformance. Growth dominated by 700-1,200 bps in the remaining asset classes. It was an historic and global run—the past 12 months were the third-worst year of performance (using rolling quarterly observations) for EAFE Value versus EAFE Growth since 1970. Given that these 131 rolling one-year periods cover 38 years, this implies a 40-year storm for international value investors!

Amidst this environment, RAFI applications have witnessed a range of excess returns versus their cap-weighted counterparts. As Table 1 shows, the results in the less-efficient markets (emerging markets and non-U.S. small company) added value, while those in the most-efficient markets (developed large—both U.S. and developed ex-U.S.—and U.S. small-mid) trailed their respective benchmarks for the 12 months ending June 30, 2008.

The modest shortfall in U.S. small companies and developed ex-U.S. large companies is well within the projected range of relative performance compared with cap-weighted indexes, particularly given the vast underperformance of value in these domains. In fact, our research suggests that we would expect to incur these types of results once every six or seven years.[1]

The recent underperformance in U.S. large companies, however, is somewhat larger than our research suggests is normal, even given the magnitude of the underperformance by the cap-weighted value indexes. Figure 2 plots the RAFI U.S. large company rolling one-year excess returns. The past 12 months' relative return is pretty far to the left of the distribution, suggesting something on the order of a 1-in-15-years event. Let's explore why.

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