RAFI In Down Markets

The recent relative underperformance has come during a period of negative returns in the equity market—a time when our research has shown that the Fundamental Index methodology tends to excel. Part of the explanation is that over the past 12 months, low-multiple companies and value sectors have significantly underperformed, which is quite rare in bear markets.

Recall, capitalization weighting places a greater emphasis on the perceived future growth of a company; thus, expected future growers will have a higher allocation. Meanwhile, slower growers, weighted by current economic scale, will have a higher relative weight in the Fundamental Index portfolio. For this reason, on average, the RAFI strategy has an inherent value tilt relative to cap-weighted indexes, exactly mirroring the market's growth bias relative to the broad economy.

In most down economic periods and bear markets, it is well-documented that value outperforms growth, especially in the late stages of a bear market! Liquidity is still available, and financing costs for leveraged borrowers typically stay the same on a nominal basis—spreads rise, but this is typically because government bond yields fall. Likewise, commodity prices tend to drop as slowing aggregate demand leads to reduced raw goods consumption. Thus, the slower growers, capital-intensive and financially leveraged companies often typical of RAFI overweights, can weather these more-conventional storms in relatively good shape. However, higher expected growers that are "priced to perfection" get routinely punished, as the Nifty Fifty of the early 1970s and the Tech Bubble of the late 1990s clearly demonstrate. And so, the reason that the RAFI approach wins, on average, in down markets is that the high-multiple companies get severely punished as the rosy economic outlook that justifies their elevated P/E ratios fails to materialize.

The past 12 months has been an exception to this rule: Low-multiple companies and value sectors underperformed significantly. Many of these firms suffered against the headwinds of rising yield spreads and commodity prices, whereas many of the growth companies have been able to withstand these strong headwinds ... so far.

The Impact Of Rebalancing

A significant contributor to recent FTSE RAFI US 1000 underperformance is that the index was reconstituted in March 2008. In hindsight, second-quarter returns would have been better by 2.3 percentage points (pps) without the rebalance. In fact, the most recent rebalance finally moved the RAFI portfolio to a moderate overweight stance in financials (before the March 2008 rebalance, we were only 1% above the cap weight, despite our inherent value tilt!). We have long advocated that one of the chief benefits of the Fundamental Index approach is the manner in which it contratrades against recent market trends by rebalancing company prices back to fundamentals. In so doing, a Fundamental Index portfolio will contratrade against style fads and crashes, sector fads and crashes, and even individual company fads and crashes.

Just as most practitioners believe that rebalancing our asset allocation is a powerful tool in our investing tool kit, a Fundamental Index portfolio rebalances within our equity holdings. However, rebalancing can sometimes be a shorter-term detractor from portfolio performance when market trends—positive or negative—persist. For example, rebalancing away from technology and other high-flying growth stocks—especially those with negligible sales and no profits—in the late 1990s left relative gains on the table for a period of time. Rebalancing did pay off, however, once gravity finally took over and the emerging growth shares crashed back to Earth.

On the opposite end, rebalancing into stocks (or asset classes) that continue to underperform will also cause short-term disappointment. This is exactly what occurred with the FTSE RAFI US 1000 and other valuation-indifferent indexes in March 2008. As an example, the FTSE RAFI US 1000 held 18.8% in financials prior to the March rebalance and 25.2% subsequently. Given that financials declined 18.3% from the end of March through June 30, this cost us over 100 bps in returns versus a portfolio that bypassed reconstitution. Similarly, rebalancing away from energy cost nearly 50 bps during the quarter. In our minds, this is more of a rebalancing timeliness issue than an indictment of the Fundamental Index strategy. Indeed, it's hard to find an investment professional who doesn't advocate rebalancing as a fundamental (pardon the pun) investment activity.

Changes At The Top

With all the movement in the market, it is fascinating to note the changes in the top 10 companies—both in terms of names and weights. As Table 2 shows, there is a compression in the fundamental size measures as of June 30, 2008. Note also that the overlap on these two lists is now down to only six companies (it was eight at March 2007 rebalance), and financials occupy zero spots in the S&P top 10 (indeed not a single one of the top 15!) at this stage. Citigroup, JPMorgan Chase, Wal-Mart and Verizon are all huge, but the market doesn't think their future prospects deserve a top 10 ranking. Reciprocally, the market believes that Procter & Gamble, Johnson & Johnson, IBM and Apple will all be a more important part of our future economy than the four out-of-favor names, even though none of these four ranks in the top 10 based on the current scale of their enterprises. Even if the market is right about most of these, it still means that the RAFI strategy can add value in the one or two whose prospects are underestimated and the corresponding one or two on the list whose prospects are overstated.

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