Despite moderately high valuations, the equity markets roll on in the mother of all recoveries. The six months ending August 31, 2009, were the best six months of performance for the S&P 500 Index since 1975, a mirror image to the previous six months, the worst since 1932. Within equities, the Fundamental Index^® methodology continues to add substantial value with almost all FTSE RAFI^® applications worldwide; nearly 98% of the apples-to-apples comparisons have exceeded the returns for the corresponding capitalization-weighted indexes on a year-to-date basis through August 2009. The breadth of Fundamental Index outperformance was exceeded only by the magnitude. For example, year-to-date the FTSE RAFI All World 3000 Index achieved an excess return of 15.3% over the MSCI All Country World Index.

Are the FTSE RAFI portfolios adding value or is capitalization weighting underperforming? The answer depends on the frame of reference. From the market vantage point, RAFI portfolios are active, value-tilted portfolios, so they are delivering an impressive positive alpha this year, outpacing all previous years except 2000. But, there’s another frame of reference: the economy. From the vantage point of the broad sweep of companies that comprise the broad publicly traded economy, the market is making constantly changing active bets on which companies have strong growth prospects deserving a premium multiple and that face challenges worthy of a deep valuation discount. From this economic frame of reference, the cap-weighted market is an active growth-tilted portfolio with the RAFI approach contratrading against these constantly changing market bets.

The excess returns for 2009 have been largely driven by the annual rebalance of the FTSE RAFI series in March when the Fundamental Index portfolios added to stocks whose share prices had fallen substantially more than their underlying economic fundamentals. Invariably, these net purchases occurred in the most distressed areas of the equity markets—financials and consumer discretionary stocks. True to mean reversion, these left-for-dead companies have led the market comeback. A recent Barron’s article indicated the “…junk rally, in which financially dodgy companies that were granted a reprieve by healthier credit markets have seen their stocks double and triple and price.”¹

On the heels of RAFI outperformance in a low-quality rally, some question whether the Fundamental Index approach is simply a permanent bet on “junky,” lower-quality companies. Our research indicates this is not the case. Rather, the RAFI methodology offers a mirror image of the cap-weighted market’s bets relative to the economy. Whatever the market is bidding up—faster than its economic footprint is growing—we sell. Whatever the market is punishing with lower valuation multiples, we buy. At any snapshot in time, the RAFI portfolio looks like a value-tilted active portfolio relative to the market; but its incremental return comes largely from this contratrading against the markets’ most extreme bets and constantly shifting expectations, rather than from the value tilt per se.

Recent Quality Performance

Although there is no definitive industry-wide classification system, quality stocks are generally associated with larger companies that have stable earnings, stable dividends, and low debt. On the other hand, low-quality stocks are associated with companies that have more unpredictable earnings and higher debt. With this unreliability, lower-quality stocks tend to trade at lower price-per-share levels. Thus, share price is a simple proxy for quality. By this admittedly crude measure, the past five months was unquestionably a low-quality rally as evidenced in Figure 1. We’ve whimsically referred to it as “garbage floating to the surface.”

Stocks in the Russell 1000 Index priced below $5 per share (as of March 31, 2009) surged over 116% in the subsequent five months. Meanwhile, stocks priced above $50 per share—a loose proxy for higher quality—managed to post a more pedestrian gain of 22% over this period. Because these stocks were priced so low, the cap-weighted Russell 1000 only had an allocation of 1.5% as of March 31, while the FTSE RAFI US Large Company Index, fresh off of its March rebalance, held 11.2% in stocks priced under $5—many of them familiar blue chips, such as Citigroup and Ford Motor, that have since fallen on hard times.

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