Market efficiency lies at the heart of the Fundamental Index^® debate.

Advisors and consultants have long advocated that market efficiency varies by equity market segment, with U.S. large companies being among the most efficient and emerging markets among the least efficient.

Factors influencing the extent of mispricings within these markets include the flow and availability of information, analyst coverage, transaction costs, and the sophistication of local investors.

In this issue we discover that the expected value added from the Fundamental Index strategy rises in inefficient markets, making it an attractive alternative to traditional active management.

By construction, stocks that trade above their eventual (but currently unknowable) fair value will comprise a larger portion of the cap-weighted index. Meanwhile, shares priced below fair value will comprise less of the cap-weighted index. As the overpriced subsequently underperform, their relative losses overwhelm the underpriced shares' outperformance because the overpriced comprise more of the portfolio. The resulting return drag was documented to be over 2% per annum in our original research on U.S. large companies.¹ The Fundamental Index concept was designed to eliminate this return drag by weighting stocks by financial measures of firm size.

U.S. large companies are largely considered the most efficient stocks. An extraordinarily mature market, accurate data on these companies extends back at least 40 years and is easily accessible from even widely used public Internet portals. Further, these companies receive the most research coverage-witness the 30-plus analysts on Wall Street that follow Intel with its $125 billion market cap versus the 3 analysts that research small-cap Avista Corporation (a $1 billion market cap Northwest utility). Transaction costs are low and liquidity high in large-cap companies, ensuring that traders can move quickly and efficiently to correct perceived mispricings. Other developed country equity markets are similarly efficient.

As we move away from large-cap, developed country equities, the various "frictions" increase and result in less-efficient pricing of individual securities. The result is mispricings that are wider in magnitude. What happens to a cap-weighted index in such markets? Because weights are linked to price, even more weight is allocated to the overvalued and even less to the undervalued stocks. In this manner, as seen in Figure 1, the return drag from cap weighting rises in less-efficient markets.

Figure 1. Return Drag of Cap-Weighted Indices

Source: Arnott, Robert D., and John M. West. 2006. "Fundamental Indexes:
Current and Future Applications." A Guide to Exchange Traded Funds and
Indexing Innovations-Fifth Anniversary Issue. Institutional Investor,
(Fall): 111-121.

Inefficient markets such as small-cap stocks and emerging markets also exhibit a higher frequency of mispricings. A greater number of stocks can be expected to be priced well above (below) fair value at any given point in time. With so many mispriced shares continuously reverting toward fair value, the return drag from cap weighting becomes more reliable in less-efficient equity segments. These markets aren't dependent on a few big bubbles to generate excess returns as some critics assert.

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.