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What do these relative valuation multiples imply about forward-looking relative return prospects for the Fundamental Index approach? We attempt to answer this question by looking at historical three-year excess returns of RAFI US Large over the S&P 500, subsequent to periods of wide divergence in P/Bs. As Figure 3 shows, there is a link between P/Bs and subsequent returns. Wide discounts bode well for future Fundamental Index performance. From 1964–2008, the RAFI US Large achieves an average annualized excess return of 3.6% when its P/B is at a 27%-or-more discount to the S&P 500. Furthermore, it does so with consistency, as evidenced by its “batting average”—winning 82% of the time and losing just 18% of the time. The next tier—discounts ranging from 20% to 27%—approaches the long-term historical average excess return for the Fundamental Index strategy of 2.0%, with a still-impressive 74% batting average. Discounts narrower than 20% lead to relative modest outperformance and only a 50/50 win rate.
Intuitively, we can interpret these results as follows. When expectations change rapidly, investors often let the pendulum swing too far. They extrapolate the good news (e.g., thinking the new economy growth stocks in 1999 would crowd out the old economy stocks for years to come) and the bad news (e.g., thinking the meltdown in financials and consumer discretionary companies in 2008 presage many years of depression). We don’t mean that the market routinely gets things wrong. In fact, recent research shows that growth stocks do indeed deliver better operating results and value stocks deliver poorer results, on average.1 Nevertheless, we have also discovered that although investors, on average, have been able to determine the future growers, they have done a terrible job of assigning the right price to that growth. Thus, future growth tends to be overpriced and future disappointment tends to be underpriced. We believe that expectations that are right in direction but overly optimistic or pessimistic are mispricings.
By design, the Fundamental Index approach avoids the return drag caused by capitalization weighting. It anchors a company’s weight on fundamental measures of company size and rebalances back to these measures annually. Rebalancing, whether among asset classes or within asset classes, is a proven investment tool that reduces risk and increases return over long periods. Over the short term, rebalancing proves frustrating because markets can take some time to revert to their mean returns. (Ask anyone who rebalanced into stocks at the end of 2000, 2001, and again in 2002!) But, reversion to the mean eventually takes place and rewards the disciplined investor who rebalances. Faith in rebalancing combined with a highly discounted current RAFI portfolio portends a bright horizon for those equity investors willing to stray from the cap-weighted indexing convention.
1Arnott, Robert, Feifei Li, and Katrina Sherrerd. (Forthcoming 2009). “Clairvoyant Value and the Value Effect,” Journal of Portfolio Management.
© 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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