Unquestionably, the relative cheapness of the RAFI portfolio at the end of the first quarter was driven by large exposures to the unwanted and left-for-dead deep value companies. But any asset is attractive at some price. That price appears to have been reached near the end of March, judging by recent performance. RAFI portfolios soared in April in absolute terms and especially relative to the cap-weighted alternatives. April was the best month ever for FTSE RAFI US 1000 relative to both the S&P 500 Index (9.33% excess return) and the Russell 1000 Value (8.18% excess return.) In fact, the U.S. large-company segment was hardly alone, as many FTSE RAFI portfolios had their best month ever as evidenced in Table 2. It's shocking to note that this result was achieved merely by reweighting the deeply loathed segments of the market back up to their economic scale, based on long-term sales, profits, dividends, and current book values. These indexes include the growth stocks, at their full economic weight, not just deep value.

After the stellar results of April, the performance of RAFI indexes is now at or ahead of capitalization weighting for the month, the year-to-date, and the past 12 months. Extending the comparison to three years, seven of the nine RAFI applications show value add. For those that claim the Fundamental Index strategy is repackaged, backtested value investing, the FTSE RAFI All World 3000 Index has achieved excess returns of 2.9% above the MSCI All Country World Index since the beginning of 2005, when our methodology was already established and about to be published. But, it achieved an even larger 3.1% per annum excess return above the MSCI All Country World Value Index. Value underperformed over these 4¼ years, but RAFI portfolios prevailed handsomely and globally.

It feels like something of a vindication for an idea that was drawing increasing heat.² How did a concept go from goat to hero so fast? By simply following its annual rebalance of each stock to the company's long-term fundamental scale in the economy, the RAFI strategy automatically contra-traded against the greatest fear-driven market of our lifetimes. On the flip side, what did the cap-weighted indexes reflect? Because their weights drift with price, they had next to nothing remaining in the left-for-dead financials and cyclicals that led the recent market rally.

Rebalancing isn't always a profitable activity. Ask any fiduciary that rebalanced away from stocks in the 1980s and 1990s or into stocks during the two extended bear markets of this decade. But it does pay off over longer periods? The same goes for rebalancing, for contra-trading, within the equity markets. What we've lacked in the past was a sensible anchor for rebalancing within the stock market. Equal weighting worked—the S&P Equally Weighted Index (SPEWI) has beat the S&P 500 consisting of the self-same companies by over 1.6% per year since the SPEWI was launched in 1990. But, equal weighting has no economically meaningful foundation for the chosen weight. The RAFI strategy uses the fundamental economic footprint that a company occupies within the broad economy as an anchor for rebalancing; that is, its main profit engine, not its preference for value stocks per se.

Racing to short-term conclusions, whether pro (April 2009) or con (2008 and first quarter 2009), on a long-term strategy is foolish. Frightful times require rigorous discipline and the long view, both of which are inherent in the Fundamental Index concept.

Endnotes

1. As an example, the FTSE RAFI US 1000 added 10% to financials, 2% to industrials, and 1% to consumer discretionary while subtracting from defensive sectors like consumer staples (-4%), health care (-4%), and utilities (-3%).

2. Evan Hessel, "Can You Out-Index The S&P ," April 27, 2009, Forbes.

© 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.

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

JOHN WEST, CFA, Director, Product Specialist of Research Affiliates, LLC.

1 | 2 |