One other factor, which we'll focus on in an upcoming RAFI Fundamentals, is the interplay between relative performance and relative valuation multiples. Intuition tells us that buying whatever has recently performed best is folly, and that whatever has plunged is (at least) more attractive than it once was. If we assume mean reversion holds, a strategy that allocates greater amounts to yesterday's laggards but only suffers a fraction of their performance shortfall would seem to be well-positioned for price reversals and deliver the goods over a full market cycle.

Many observers may miss the fact that the RAFI strategy performed very nearly well enough outside the United States, particularly in emerging markets, to offset the shortfall in the United States. Indeed, the Fundamental Index concept trailed on a global, all-country basis by a scant 60 basis points, after winning handily in 2006 and 2007—all of which occurred after the publication of our methodology and commercial indexes. We believe a 60 basis point global shortfall to capitalization weighting for 2008 is well within the range of expected outcomes in a volatile market like the current one. A prudent fiduciary maintains a long-term view and avoids making snap judgments based on short-term trends. Looking at the RAFI approach's performance over a long period of time, we are pleased to see that the cumulative outperformance remains.

Conclusion

The collective psyche of investors did a 180 in the past 12 months from a greed-induced spring bubble in commodities to the panic-driven selling of "Everything but Treasuries" in the fall. With the books finally closed on 2008, investors can finally take a breath and evaluate the dramatically altered landscape of the capital markets. This assessment will reveal a host of opportunities. The massive meltdown in virtually all risky asset classes has led many to offer healthy-looking forward returns for the first time in years—in some cases, careers. Ignoring the scars caused by the fall, a systematic and model-driven GTAA process scrutinizes this newly golden opportunity set.

The selling of distressed equities has led many companies' prices to deviate wildly from their economic footprint, exactly the kind of environment that provides attractive prospects for the Fundamental Index approach. Low-hanging asset-class fruit and an index methodology that capitalizes on the severe mispricings in today's equity market? Over the long term, investors keen on achieving sustainable investment success would be well-served to embrace both. And that's a rule we can live with.

Endnotes

1. As a barometer, consider that the average correlation of the S&P 500 with the Barclays Capital U.S. Aggregate Bond Index (the two asset classes most frequently used to offset each other) has been 0.25 since 1976.

2. A correlation of 0.58 is virtually identical to the historical correlation between the MSCI EAFE and S&P 500 since 1970 (0.59).

3. This spread was calculated as the difference between the Merrill Lynch USD Emerging Market Sovereign Plus Index and the U.S. five-year (constant-maturity) T-note. Investment-grade percentages are based on the JPMorgan Emerging Markets Bond Index, courtesy of PIMCO.

4. Performance through August 2008 represents Research Affiliates simulated results. Performance for September 2008 through December 2008 is that of the FTSE RAFI All-World 3000 Index.

5. A possible explanation for these differences is the rebalancing methodologies used by the three cap-weighted index providers. Frank Russell Company rebalances at the end of June; S&P/Citigroup in December.

6. Note that in past bear markets, most of the outperformance by the value stocks happened in the second half of the bear market. This fact invites a provocative question: Is the bear market of 2007-2008 over?

7. Indeed, we can venture back to the depressionary 1930s to see value shares underperforming growth in a severe down market. The Frank Russell Company indices don't extend this far back, but Gene Fama and Ken French constructed the Fama-French Large Cap Growth and Value time series to illustrate style performance during this stretch.

8. See the August 2008 issue of RAFI Fundamentals, "The Anti-Bubble Bursts."

© Research Affiliates, LLC 2009. 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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