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Aon Hewitt Retirement and Investment Blog

Fundamental Indexation: Why you might not get what you think

Investment life has never been more complicated, with a gamut of new investment classes springing up every day, at a time when the traditional assets (equities, bonds) have rarely been so expensive. Whilst many of our clients are wading into these muddy waters with a can-do attitude, an increasing number are going the other way and opting to keep it simple. One popular way to do this is through factor based investing, or to use the rather oxymoronic marketing term "smart beta". These are low cost, rules based indices that focus on specific market factors, such as low volatility, value or momentum, in order to improve long term returns.
 
The idea is to find a better way to invest in markets (mainly, but not solely, in equities) than using the universal benchmark – the market cap weighted index. The problem with using market cap as weighting criteria is that the largest and most popular companies have the biggest weight, whilst the least popular, the downtrodden and the small fry have smaller weights. This way, the investor becomes beholden to what happens in a few mega companies, which may have nothing to do with the market as a whole. Are you really investing in the entire "market" in its purest sense with a FTSE All Share, for example?
 
So, break this link to market cap, reduce your exposure to the behemoths and spread the love across the market. This is the mantra of the "smart beta" world and fundamental indexation is a prominent sub-set. Here, the weightings are calculated using criteria, such as sales, cash flow, dividends and book value, making the index look very different from the market cap. The Research Affiliates Fundamental Index, or RAFI for short, is generally the best known example and, as the chart shows, it has outperformed the market cap index over the past 15 years, hence the attraction for investors.



While the focus is on the "fundamentals", the consequence is often that the index becomes weighted towards value stocks. Indeed, many investors may choose to invest in the RAFI because it's a low cost way to gain exposure to a factor that has shown to deliver outperformance over long periods of time.  But look at that chart again – not all value is created the same and the sharp outperformance relative to a more traditional value weighted index hints that treating RAFI as purely a value index could be naïve thinking.

Unintended risks and long cycles in performance
 
Historical data shows that the RAFI is consistently weighted towards value stocks but that the strength of this weighting waxes and wanes. We can also see that the market is sliced and diced differently to other value weighted indices – there is more in energy companies at the moment, for example, and the emphasis on companies with high sales is greater. The proponents of the RAFI say this explains its superior performance to other value indices but are they simply guilty of extrapolating the past into the future? Was the past 15 years just a set of serendipitous circumstances that will not be repeated? We may have some cause to worry if recent performance is anything to go by.
 
While the FTSE RAFI All World 3000 index (the most global version) outperformed the MSCI All Country World index over 15 years (9.9% annualised versus 7.3%), it has struggled with underperformance for over three years now (6.6% versus 7.8% since January 2014). What to make of this? Is the game over?  Not necessarily, but it does highlight an important risk of all forms of factor investing. Performance is reliant on specific market conditions that can be absent for multi-year periods, creating sustained underperformance. The picture below is something that could give investors nightmares!



Another big risk is that you will be replacing undue exposure in one set of companies with undue exposure in another set. The mega companies may be less of a problem but the large overweight to energy companies and the large underweight to technology companies may be crucial! So, what would happen if new technology completely disrupts the oil market, causing prices to crash? Would the sharp underperformance of the RAFI in this scenario really be down to value stocks falling out of favour? We think not.

The game isn't over for RAFI
 
Having said all of this, we believe that there is still life in the strategy yet. As we mentioned, the market environment is a key influence on returns and this can be boiled down to where interest rates are headed. Interest rates tend to rise when economic growth and the profits outlook improves, precisely the environment in which many value stocks thrive. So, our view that interest rates are likely to rise gradually over the next few years should be helpful for value stocks in general. As for the RAFI, it's very underweight in technology stocks, which have performed incredibly well. Nonetheless, when we peer over the horizon, we can't help but thinking their expensive valuations may be a hindrance – this will support the RAFI too.
 
So we think the RAFI will gradually outperform the market cap index and most likely other factor indices that are more attuned to weaker markets, such as low volatility equities.
 
But the story doesn't end there, because we think there are more effective ways to invest in factor indices than simply picking one and running with it. Combining factors can help to mitigate their strong cyclicality because they don't all underperform at the same time. Aon is currently working on finding optimal ways of achieving this aim so stay tuned.
 
For more details, here is a link to our full research note on Fundamental Indexation.
 
Koray Yesildag is a Principal, Asset Allocation Specialist based in London.

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