Assets Based On RAFI Fundamental Index Concept Pass $100 Billion Mark - Smart Beta Strategy Draws Interest From Large Institutions And Retail Investors

Assets invested based on the RAFI® Fundamental Index® approach have surpassed $100 billion globally.  This milestone represents broad acceptance by institutional and retail investors of these smart beta strategies.
 
“When we developed the Fundamental Index strategy, we knew it was a big new idea. But its growth has exceeded our expectations, and the concept continues to attract interest from the largest institutions to Main Street investors,” said Rob Arnott, chairman and chief executive officer of Research Affiliates, LLC.
 
Assets based on the RAFI Fundamental Index concept have climbed to $107 billion as of Sept. 30, 2013 from the first investments made in 2004.
 
During the aftermath of the tech-stock bubble collapse in 2000-2002, Arnott searched for a better way to index securities than using market capitalization. Cap-weighted indices fully reflect market bubbles, crashes, and speculative behavior. By construction, these indices overweight any overvalued securities and underweight any undervalued ones. The result is a portfolio weighted toward the most popular, momentum-driven securities and under-allocated to unloved, out-of-favor securities that trade at a discount.
 
Arnott and Fundamental Index co-creator Jason Hsu tested various measures of company size—company sales, revenues, reported earnings, cash flow, number of employees, dividends paid, and book value, among others. To their surprise, they found that all measures beat the Standard & Poor’s 500 Index by significant margins over long time periods. Their research, published in the Financial Analysts Journal in 2005, found that market-cap weighting leads to an average 2% drag on returns in developed markets and more in less efficient markets.
 
Their research yielded a key revelation: All of the measures broke the link between a security’s price and its weight in the portfolio, in contrast to the cap-weighted index.
 
“Traditional cap-weighted indices are built on the assumption that prices are efficient.  For institutional investors who use both passive indexing and active management, which assumes inefficient markets, this represents a schizophrenia in investment beliefs,” said Jason Hsu, Research Affiliates’ chief investment officer. “We wanted to design an index that assumes market inefficiency—an index that is appropriate for and benefits from inefficient prices,” he explained.
 
Still, with worldwide index assets totaling $7.3 trillion, the Fundamental Index strategy has lots of room to grow. “While $100 billion represents fantastic growth for a new strategy within the span of a decade, the good news is there remains lots of capacity for new growth and little threat of volume affecting the added value provided by the strategy,” said Chris Brightman, head of investment management.
 
“We are seeing flows from both traditional cap-weight index portfolios and from active management,” said Michael Larsen, global head of affiliate relations. “Investors have realized that market-cap weighting is not optimal and are interested as well in viable alternatives to more costly active management.”
 
Research Affiliates partners with leading index providers to build and track indices, which are then licensed to large asset owners and leading investment managers.  FTSE and Russell Indexes are global index calculators for their respective Fundamental Index series, while China Securities Index Co. and the Taiwan Stock Exchange offer index products in Greater China based on the Research Affiliates methodology.
 
The RAFI suite of smart beta products has expanded to include index series for bonds and low-volatility equity. Citi, the leading global financial services company, calculates the Citi RAFI Bonds Index Series in conjunction with Research Affiliates. Ryan ALM, Inc., an asset and liability management firm, calculates the RAFI U.S. corporate bond indices.