When we published our initial research in 2005 on the Fundamental Index® methodology for the U.S. market, we found the strategy produced 2% a year in outperformance over a 43-year period (see table below). Since then, we have tested the methodology in 23 markets worldwide, and find that it works.  In fact, we find that the methodology works better in smaller and emerging markets than it does in developed markets. 

The RAFI methodology weights a company in relation to its economic footprint, as measured by widely accepted measures of company size, including five-year averages of company sales, profits, and dividends. These measures are less susceptible to gaming, rely on easily accessible data, are not intended to be predictive of future size or value, and are broadly available across countries. It doesn’t matter how many factors are used—it could be five or six or just two. The key is that they minimize the return drag associated with cap-weighted index approaches that overweight overvalued stocks and underweight undervalued stocks. Systematically rebalancing to target portfolio weights provides the main source of added value.

Using only a single measure of firm size, however, has its drawbacks. For example, a dividend-weighted index will exclude well over half of all publicly traded companies, including many growth stocks and essentially all emerging growth companies. A sales-weighted index would clearly favor low-margin companies over more profitable firms and so on. Multiple metrics of company size results in a broader and more representative investment portfolio.

The Fundamental Index methodology is explained in "Fundamental Indexation" by Arnott, Hsu, and Moore (2005) and in our newsletter Fundamentals.

For articles citing these strategies, please see In the News. For more information about RAFI Equities, please see the RAFI FAQ.

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