Our research results confirm these two claims: the Fundamental Index advantage widens and becomes more consistent as we move down the "efficiency curve." Table 1 shows the results for a RAFI^® portfolio versus representative cap-weighted indices in selected market segments. Starting with U.S. large-cap stocks, we see an annualized excess return of 2.0% with a "batting average" of 73.9% over rolling three-year periods. In other words, the RAFI strategy beat the S&P 500 in nearly three-quarters of all of the three-year periods rolled monthly since inception. The developed equity markets outside the United States are arguably less efficient.² In this area, the Global ex U.S. RAFI portfolio shows 3.3% annualized value added over the MSCI EAFE Index while the three-year batting average increases to nearly 90%. A similar excess return advantage accrues to both U.S. and Global ex U.S. small-cap Fundamental Index investors with a premium of 3.4% and 4.5% at a remarkably reliable three-year win rate of over 99% and nearly 95%, respectively.

Table 1. RAFI Performance through December 2007

Emerging markets, intuitively the most inefficient equity market of all given the history of high transaction costs and economic turbulence, extends the Fundamental Index premium to an astonishing 10.7% annually and has yet to experience a three-year performance shortfall since the inception of our data in 1994.

In conclusion, the Fundamental Index strategy is a tremendously useful tool for less-efficient equity market applications. The value-added relative to the cap-weighted indexes is consistent with active manager expectations. For example, the Lipper Small-Cap Core Mutual Fund Universe top quartile fund sported a 10-year excess return of 2.8% over the Russell 2000 Index as of December 31, 2007.³ Yet, unlike active managers, the Fundamental Index strategy maintains the broad coverage, high capacity, and low fees reflecting the positives of index implementation. It is a unique proposition and one that deserves serious consideration as a one-stop alternative for filling an investor's international, small company, and emerging market allocations.

Endnotes

1. Arnott, Robert D., Jason Hsu, and Philip Moore. 2005. "Fundamental Indexation." Financial Analysts Journal, vol. 61, no. 2. (March/April): 83-99

www.rallc.com/ideas/pdf/fundamentalIndexation.pdf

2. One manner to gauge a market's efficiency is to compare the returns of active managers to the cap-weighted index. On this measure, international markets

appear to be as efficient as U.S. large caps over the past five years.

3. Based on data from eVestment Alliance

© Research Affiliates^®, LLC 2008. The material contained in this newsletter is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any securities transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. Neither Robert D. Arnott nor Research Affiliates and its related entities warrants the accuracy of the information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this newsletter is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this newsletter should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.

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