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On RAFI, Factors, and Beef Stew

Tom Goodwin, PhD

On New Year’s Day I decided to start out the year by cooking for friends and family, something I have rarely done since moving to New York.  The main dish was an Ethiopian beef stew, which is very spicy and is served with couscous.  No one would confuse it with an ordinary beef stew. And yet the nutritional ingredients of both stews are very similar.  That got me to thinking about factors and fundamental indexes. (I know, get a life.)  Stay with me though, because there is a striking parallel.

The relationship between an index and factors is analogous to the relationship between a cooked dish and its nutritional ingredients.  Knowledge of the nutritional ingredients of one’s diet is extremely helpful; it allows one to adjust if, say, there are too many carbohydrates or not enough protein.  But it would be wrong-headed to turn that relationship on its head and think that any two dishes with similar nutritional content are going to look, smell and taste the same.  That wouldn’t leave much room for the art of cooking!  This leads me to my point.

We are now celebrating the 10th anniversary of the FTSE RAFI Fundamental Index Series, often hailed as the real beginning of smart beta indexing.  And yet one still hears assertions that RAFI is nothing more than a value index, based on the fact that it has that ingredient in strength.

To understand why the RAFI “dish” is more than the value “ingredient” we have to look at how it is constructed.  Value indexes are constructed by heavily weighting stocks that are “cheap” as measured by price ratios such as book-to-price, dividends-to-price and sales-to-price.  RAFI breaks the link with price by just using the fundamentals such as book value, dividends and sales revenue, without dividing by price.  Changes in the weights are going to be correlated: when sales increase (decrease) the weights of both types of indexes will increase (decrease) for example.  But while a stock price increase (decrease) moves a value weight downward (upward) it does not affect the RAFI weight, and that’s where important differences arise.

The similarities and the differences between RAFI and value indexes means that at times they will have similar return patterns, but at other times the return patterns diverge meaningfully.  We can see this through recent history in the US.  The chart shows that in the last three years the return patterns of RAFI and the Russell 1000 Value indexes have been very similar as all value strategies have suffered in what has been a growth-dominated market.  But in the turbulent period of the Global Financial Crisis, RAFI and Value return patterns sharply diverged.  This divergence is due to several differences in RAFI index construction, or how the index dish is prepared.  This includes the absence of a link to price and downward adjustments in weights for leverage, which had a large impact on the weight for the financial sector.

Source: FTSE Russell.  Data as at 31 December 2015. Past performance is no guarantee of future results.  Please see the final page for important legal disclosures.

To be sure, the introduction of factor allocation analysis into portfolio construction has been a great leap forward for market participants wanting to have a better handle on what “ingredients” are in the indexes they might consider.  Factor indexes allow adjustments to produce a desired set of factor exposures, with the right nutritional balance, so to speak.  But alternatively-weighted indexes like RAFI are more than the sum of their factor parts and should be assessed accordingly.  The proof is in the eating!


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