EQUITIES
BONDS
STYLE
LONG/SHORT
Is the RAFI strategy really an "index?"
The answer depends entirely on how one defines an "index." From the perspective of the Capital Asset Pricing Model—the seminal work that relates the price of each security to the market as a whole—anything that's not cap-weighted is neither passive nor is it an index. By this definition, a Fundamental Index strategy is neither passive nor an index. If, alternatively, we define an index as something which is formulaic, objective, transparent, historically replicable and low-turnover, a Fundamental Index strategy qualifies on all counts.
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Does the RAFI
strategy have a bias toward value and smaller cap stocks?
RAFI strategies have a value tilt but very little small-cap tilt. These tilts, however, are dynamic: when value stocks are out of favor and thus are cheap, Fundamental Index strategies tend to increase their allocation to deep value stocks; this phenomenon was vividly displayed in March 2009 when financial, industrial and consumer discretionary stocks when priced at bargain-basement levels. When value is in favor, the value tilt is much milder because these stocks tend to be priced higher. Rebalancing into unloved stocks and out of the most popular stocks—which we call "contra trading"--provides the majority of RAFI strategies' added value.
See the August 2007 and July 2010 issues of Fundamentals for a description of the dynamic nature of the RAFI value and size tilts.
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What happens when value
is out of favor?
When growth and value have similar returns, the Fundamental Index strategy should win. Why? Because its design prevents it from overweighting overvalued companies and underweighting undervalued companies relative to their true fair value. When value is winning, the RAFI strategy has a tailwind. When growth is winning, the RAFI strategy's added value goes down and, in a strong, momentum-driven growth market, can easily go negative.
Fortunately, we can have some confidence that momentum-driven growth markets do not go on forever and that, by the time they are over, the RAFI strategy will have such a strong value tilt that it will benefit handsomely from the return to value. The Fundamental Index strategy contra-trades against whichever style is in vogue.
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How does
the RAFI portfolio compare with other passive equity investment alternatives?
We examined a number of alternative approaches, including diversification-based investing, minimum variance, and maximum diversification models. Our research shows that all of these strategies—including the Fundamental Index approach--derive their added value from the same sources and are thus similar to naïve equal-weighting approaches, such as the S&P 500 Equal Weight Index.* The key issue is that all of these alternative index strategies break the link between price and security weight and performed very well relative to a cap-weighted index. However, implementation costs, liquidity and capacity constraints distinguish them: only the Fundamental Index methodology did well in all three categories.
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Who calculates the equity index?
FTSE and Russell, leading global index providers, calculate the FTSE RAFI Index Series and the Russell Fundamental Index Series respectively. For more information about FTSE and its series, please visit FTSE's website. For more information about Russell and its series, please visit Russell's website.
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Why does the RAFI methodology work with bonds?
The same market inefficiencies that affect cap-weighted equity indices also apply to fixed income. In addition, traditional bond indices give their greatest weights to the largest debtors. Should investors buy more of a company or nation's debt solely because it increases its issuance? Intuitively, fundamental measures of company or country size offer advantages over market-weighted fixed-income indexes. Sales, cash flow, book value of assets, and dividends represent metrics that can impact a corporate issuer's ability to repay debt. Similarly, GDP, energy consumption, population, and rescaled land area are broadly representative of a country’s economic size and are related to its ability to service its debt.
As with equity portfolios, the amount of outperformance increases in noisier bond markets. Our research, published in the Journal of Porfolio Management, shows that the Fundamental Index methodology applied to high-yield corporate bonds outperformed a cap-weighted benchmark by 260 bps per year; applied to investment-grade corporate bonds surpassed the relevant Merrill Lynch benchmark by 42 bps per year; and applied to emerging-market bonds beat a market-cap-weighted index by 143 bps per year. The time period measured was January 1997 through December 2009.
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Does the strategy make duration or credit bets?
RAFI fixed-income strategies are not designed to make either credit or duration bets. However, RAFI corporate bond strategies will tend to have higher credit ratings than their market-weighted counterparts. By basing issuers' weights on the fundamental factors, RAFI strategies are explicitly weighting issuers by variables that impact issuers' ability to repay debt. If all else is equal, a firm with relatively high cash flow will be better equipped to repay a given level of debt than a firm with relatively low cash flow. In contrast, traditional bond indices weight issuers solely by the market value of each firm's outstanding debt with no regard to underlying firm fundamentals.
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Are there parts of the economic cycle where the strategy underperforms the
cap-weighted index?
In looking at the performance of RAFI corporate fixed income during different economic cycles, we examined performance during bull and bear markets and during periods of rising and falling interest rates. While RAFI bonds did not underperform during any of the periods, outperformance was far more pronounced during bear markets and periods of falling interest rates. Outperformance during these periods of market distress is most likely attributable to the quality bias of the RAFI strategies in relation to their cap-weighted counterparts.
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Who calculates the RAFI bond index?
Citi, the leading global financial services company, calculates the Citi RAFI Bond Index Series. Citi has approximately 200 million customer accounts and does business in more than 160 countries and jurisdictions. The Citi RAFI Bond Index Series is available in
The Yield Book.
The index series is available for licensing from Citi. Ticker symbols are:
CRFDMU – Citi RAFI Sovereign Developed Markets Bond Index Master
CRFDU – Citi RAFI Sovereign Developed Markets Bond Index Liquid
CRFELMU – Citi RAFI Sovereign Emerging Markets Local Currency Bond Index Master
ERFEMLU – Citi RAFI Sovereign Emerging Markets Local Currency Bond Index Liquid
Ryan ALM, Inc., an asset and liability management firm, calculates the RAFI U.S. corporate bond indexes. The firm was founded by Ron Ryan, CFA, a pioneer in bond and liability benchmark design.
The index is available for licensing from Research Affiliates. The ticker symbol for the U.S. corporate high-yield bond index is RAFIHY; for U.S. investment-grade bonds, the symbol is RAFIIG.
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How does the RAFI® Fundamental US Style Index partition the universe by size?
The Series partitions the universe of the largest 2,500 U.S. companies as measured by their fundamental weights (using measure of sales, cash flow, dividends, and book value) into three size tiers. The securities that comprise the top 70% by fundamental weight are assigned to the large company tier, the securities that comprise the next 20% are assigned to the mid company tier, and the securities that comprise the final 10% are assigned to the small company tier.
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How is the universe partitioned among growth/core/value investment styles?
Each security is assigned a style score, which is the difference between a company’s growth and value score. Securities in each size tier are then ranked by style score. The top 20% are assigned to the growth partition, the next 30% to the core partition, and the final 50% to the value partition.
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How does the RAFI Fundamental US Style Index Series differ from traditional style indices?
Typical style indices use market capitalization and a combination of historical fundamentals and forward-looking expectations. The RAFI Fundamental US Style Index Series uses historical fundamental factors to determine size and style and are designed to be relatively static over time. By rebalancing to weights based on historical fundamentals, the Series contra-trades against the market’s ever changing bets. In addition, RAFI style indices parse stocks among value, growth, and core portfolios, with no stock appearing in more than one portfolio. In contrast, some capitalization-weighted style indices assign growth and value weights to each stock, resulting in security overlap across different styles.
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Who creates the RAFI Fundamental Style Index Series?
The Index Series was developed by Research Affiliates in conjunction with Dow Jones Indexes. The Series is calculated by Dow Jones Indexes, a leading full service index provider that offers more than 130,000 equity indexes. Dow Jones Indexes is the marketing name of CME Group Index Services LLC and is a CME Group Company. For each annual reconstitution, RA determines the weightings of the constituents; Dow takes those weights and applies them to the index series.
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How does the RAFI US Equity Long/Short Index correlate with different asset classes?
The RAFI US Equity Long/Short Index returns are uncorrelated with equities, fixed income and other absolute return strategies, when measured over long time horizons, as can be seen in the table below. For the 10-year period ended December 31, 2010, the long/short index returned 9.30% on an annualized basis, compared with 1.41% for the Standard & Poor's Index and 5.85% for the Barclays Capital U.S. Aggregate Bond Index, based on simulated data.
| |
As of 12/31/2010 |
| |
10-Yr Annualized Return |
10-Yr Correlation |
| RAFI US Equity Long/Short Index1 |
9.30% |
— |
| S&P 500 Index2 |
1.41% |
0.38 |
| Barclays Capital Aggregate Bond Index3 |
5.85% |
0.10 |
11Research Affiliates, based on data from Worldscope, Datastream, and Bloomberg. The return is collateralized and includes the return of a cash collateral yield (1-month T-bill).
2Research Affiliates, based on pricing data from Bloomberg.
3Research Affiliates, based on data from Barclays Capital. |
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How often and when is the index reconstituted?
The index is reconstituted annually on the third Friday of March; constituents are added or deleted based on changes in fundamental factors. Sector neutrality—meaning that weights for both the long and short legs of the portfolios are equal—is achieved during this annual reconstitution.
The index is also rebalanced monthly to achieve dollar neutrality. Dollar neutrality simply means that an equal amount is invested in both the long and short legs of the portfolio at the rebalancing.
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How should investors benchmark this index?
The RAFI US Equity Long/Short Index is an absolute return strategy, meaning that its goal is to create a positive return regardless of market conditions. This objective is unlike traditional long-only strategies which seek a return relative to a pre-specified benchmark. Benchmarking the long/short index to a long-only equity or bond strategy like the Standard & Poor's 500 Index or the Barclays Capital U.S. Aggregate Bond Index may be helpful to gauge performance during certain market conditions but not over a full market cycle. A more appropriate way to benchmark this index is against a risk-free rate (1-month Treasury bill).
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Who calculates the RAFI US Equity Long/Short Index?
The index is calculated by Dow Jones Indexes, a leading full-service index provider that offers more than 130,000 equity indexes. Dow Jones Indexes is the marketing name of CME Group index Services LLC and is a CME Group Company.
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