Here goes. My disclaimer. I don't pretend to fully grasp it all. I feel like a confused but earnest pilgrim on the road of understanding the language, the statements and the issues.
Background links (most are repeats)
1) Fundantal Indexation
by Arnott et al (only abstract - could not find public link to full article)
2) Bernsein's Fundamental Indexing and the Three-Factor Model
3) Worth The Weight?
-- A survey and critique of alternatively weighted indexes by: Steven A. Schoenfeld and Robert E. Ginis
4) Define Alpha, Beta
5) Define Fama French Three Factor Model
Some other opinions, eg -- New Frontiers In Index Investing ---An examination of fundamental indexation
-- by: Jason C. Hsu and Carmen Campollo
Are Fundamental Indexes Just Value Indexes?
By construction, fundamental indexing underweights growth companies that are not growing their fundamentals. In this regard, fundamental indexes will tend to have lower P/Es and higher dividend yields than standard cap-weighted indexes . Fundamental indexing, however, is far from simple value investing. We show the performance of the U.S. Fundamental Index 1000 against the Russell 1000 Value Index in Figure 6. The U.S. Fundamental Index 1000 and 2000 outperform the Russell 1000 and 2000 Value reliably. Additionally, we show in Figures 3A-B that the U.S. Fundamental Index 1000 outperforms the S&P 500 and the U.S. Fundamental Index 2000 outperforms the Russell 2000 in both bull markets and expansionary economic environments; value indexes do not outperform in these environments.
Additionally, value indexes are limited in capacity and do not provide broad market participation and diversification.
One reason that the fundamental indexes outperform value indexes is because value indexes are based on capitalization, and discard (or underweight significantly) many growth companies that are growing their fundamentals equally rapidly. By contrast, fundamental indexes hold a significant portion in growth companies that are growing their fundamentals.
This article presents non-US analysis data.
andFundamentals-Weighted Indexing Offers New Insight on Value Investing
-- By Eric Brandhorst, CFA, Director of Research, Global Structured Products
Fundamentals-weighted passive investing presents an intriguing alternative to both capitalization-weighted and traditional value benchmarks. From a pragmatic perspective it offers many of the benefits of cap-weighting (broad diversification, low costs, transparency, and modest turnover), but positions investors to benefit from the well-documented² value premium phenomenon. Fundamentals-weighting also offers advantages over traditional passive approaches to value investing by incorporating all stocks and responding to changes in valuation dispersion. A fundamentals-weighted approach represents a tilt toward low price-to-fundamental stocks and away from high price-to-fundamental stocks. Future performance therefore critically depends on the persistence of a value premium. A valuation errors framework suggests investors should expect a long-term value premium to persist in the future. Fundamentals-weighted passive strategies are a thoughtful way to capture that premium.
My comments:I think I agree with the statement that much or most of the RAFI index outperformance is driven by its increased "value" exposure.
I think I would be surprised if this was not so. That is the whole point of moving away from the 100% cap-weighted crieria. Thus I don't see why Bernstein thinks this is a shortcoming.
Thus, at a rough approximation, slightly less than two-thirds of the "excess return" of the RAFI over the S&P is due to naïve factor exposure, and slightly more than one-third seems to be inherent to the technique. Unfortunately, this latter effect is not statistically significant, raising the issue of data mining.
Bernstein's table of his regression analysis has numbers that I find hard to interpret as they have NO estimates of the uncertainty on the numbers. Thus one does not know if some of the differences he discusses are noise differences or significant signal differences. I think this may be one of his nore "cavalier" postings
The critical question is this: Just how much of the excess return of the fundamental indexes is due to factor exposure, and how much return above and beyond this is added by the technique of fundamental indexing?
I don't see this. My senses is that the RAFI approach gives a more real meaning to "value" rather than the traditional bifurcation of the cap-world into two parts based on P/E.
In any case my view is that the RAFI approach seems more meaningful - but given the higher MERs perhaps not more desirable.