Will some financials fall much further? Probably. Could the sector, collectively, fall more? Of course. Does it make sense that none of them—not one—ranks in the top 15 by market cap? We're not so sure about that! This rout in the financial services sector—the largest sector of the U.S. economy—bears all the trappings of an "anti-bubble," a runaway speculative avoidance of anything in the sector. We think this is a terrific opportunity to shift from the "active bets" of capitalization weighting to the economic bets of the Fundamental Index concept!

Lessons From The Past

It is worth noting that the past 12 months is atypical—but not without historical precedent. Let's review a few facts related to 1990—a similar environment to the past 12 months.

In 1990, the S&P 500 suffered a 3.1% decline, with the FTSE RAFI US 1000 posting an 8.9% loss, a deficit similar to the past 12 months. Additional comparisons between the two years are presented in Table 3.

Several trends from 1990 are worth noting as they relate to today:

• Not surprisingly, financials suffered badly in 1990, as bad loans and deleveraging impacted bank balance sheets. In 1990, financials trailed the S&P 500 by 17.7 pps as compared with a similar deficit of 29 pps in the trailing 12 months ended June 30, 2008. Both periods saw financials finish dead last among the major economic sectors.
• As they have in the past year, commodities rallied strongly in 1990 with the Goldman Sachs Commodity Index surging 29.1% after Saddam Hussein and Iraq invaded Kuwait, causing a significant spike in oil prices. However, this run-up in raw inputs paled in comparison to the 76% rise in the GSCI over the past 12 months.
• Credit was a major issue in 1990, as conditions rapidly deteriorated on the heels of the American savings & loan crisis. High-yield (corporate bonds rated below investment grade) spreads above government bonds spiked by 510 bps in 1990, indicating rising risk aversion on the part of lenders. Similarly, we have witnessed high-yield spreads jump from 440 bps from June 2007 through June 2008.
• Growth trounced value by roughly 800 bps as measured by the Russell 1000 Growth versus the Russell 1000 Value in 1990. Over the latest 12 months, growth outperformed value by nearly 1,300 bps.

Perhaps most important to investors and for the historically inclined, after the poor performance of 1990, the FTSE RAFI US 1000 Index went on to produce a five-year annualized return of 19.2% versus 16.6% for the S&P 500—an excess return of 2.6% pps per annum—bettering the 2.1% experienced over our originally tested 1962-2004 time horizon.[2] As seen in Table 4, this also doubled the incremental return of value during this period. Of course, it wasn't a linear ride each and every year above the S&P 500. Growth again surged in 1991, actually outpacing value by 1,600 bps—its third-best year ever since the inception of the Russell indices, exceeded only by the bubble-induced 1998 and 1999. Despite this massive growth headwind, the Fundamental Index portfolio finished relatively flat in 1991, but then went on to produce reasonable excess returns in the ensuing four years.

Conclusion

Mark Twain once quipped, "History doesn't repeat itself, but it does rhyme." We don't expect history to repeat exactly, but we do believe the Fundamental Index approach will weather the storm of 2007-2008 much as it has in the past. The return drag from capitalization weighting—overweighting overpriced securities and underweighting underpriced securities—is a structural long-term return inhibitor. Over shorter intervals, any Fundamental Index application may underperform by placing proportionately more in underperforming stocks than its cap-weighted counterpart. The same can be said for equal weighting or, for that matter, any other price-indifferent strategy. After all, the goal of price-indifferent indexing is to randomize portfolio weights to approximately allocate half of our money to overvalued shares and half to the undervalued.

We know that capitalization weighting will structurally place more in securities whose stocks are priced above fair value and less in those that are priced below fair value. Why? Because the weights relative to fair value are not random; they are linked to price and the errors embedded within that price! For this reason, Fundamental Index supporters—if they had existed in December 1990—would have been confident about the future prospects of the RAFI methodology, just as we are today.

1. Both RAFI Global ex-U.S. and RAFI U.S. Small Company have approximate historical, backtested excess returns of 3.4% with tracking errors of 4% through 2007. This covers 1979 for RAFI U.S. Small Company and 1984 for RAFI Global ex-US.

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

© 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.

ROBERT ARNOTT, Chairman and Founder of Research Affiliates, LLC.

JOHN WEST, CFA, Associate Director, Marketing & Affiliate Relations of Research Affiliates, LLC

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