FTSE RAFI Canadian Index ETF to launch 22Feb06

[DenisD]

It seems to me that the more interesting question is, "Is Arnott's new index fund likely to do better than a regular index fund (pick a value fund if you like) by more than the all-in fee difference?"

If I had a simple, 3 fund equity portfolio - Canadian, US and EAFE large cap index funds, I would pick the RAFI ETFs for the Canadian and US (and EAFE when available) exposure.

[George$]

... The question which is still up in the air, of course, is whether fundamental indexing even "has merit in the US" in fact, as opposed to theory. More importantly for us, AFAIK there has not been any serious testing of the theory in the Canadian context at all, so we are all equally in the dark here!

Yogi: If I may list my thoughts in shorthand as ...
(1) Indexing has merit because it can be both low cost and have broad diversification.
(2) Why is cap-based indexing the norm? I think only because someone, like S&P, started out that way decades ago. I'm not sure it was ever debated on "merit" - like we are imposing on fundamental indexing.
(3) As Arnott points out in his presentation, you would like to have an index that avoids or minimizes the worst extremes of the cap-model for an index. Thus you fold in the other actual numbers, the "doing-business" parameters. That is all to the good in my view.
(4) IF had the choice between two indexes at the SAME MER and roughly the same asset class and diversification, I think I would chose the fundamental over the cap. At present the extra cost in the fundamental index bothers me. (My Vanguard charge for our S&P500 fund is a MER of 9 basis points or 0.09%, as the Admiral rate.)

[Shakespeare]

Why is cap-based indexing the norm?

It doesn't require rebalancing, except when companies are added to or leave the index. So it has lower transaction costs and gains/losses than other weightings. That's particularly important in taxable accounts.

The problems with cap-weighting are psychological, not mechanical.

[Bylo Selhi]

(2) Why is cap-based indexing the norm? I think only because someone, like S&P, started out that way decades ago. I'm not sure it was ever debated on "merit" - like we are imposing on fundamental indexing.

I believe that the first index fund (run by Wells Fargo for the Samsonite pension plan) was equal-weighted S&P500. That proved to be problematic because the fund had to be rebalanced often, incurring transaction costs (and for taxable accounts, perhaps gratuitous capital gains tax.) The solution, cap weighting, has the characteristic that it's self-adjusting on a day-to-day basis. That makes it easy to manage and minimizes costs.

Added: Hmm...my memory ain't so bad. Bogle argues Wells Fargo was "second" and a "nightmare."

The basic ideas go back a few years earlier. In 1969–1971, Wells Fargo Bank had worked from academic models to develop the principles and techniques leading to index investing. John A. McQuown and William L. Fouse pioneered the effort, which led to the construction of a $6 million index account for the pension fund of Samsonite Corporation. With a strategy based on an equal-weighted index of New York Stock Exchange equities, its execution was described as "a nightmare." The strategy was abandoned in 1976, replaced with a market-weighted strategy using the Standard & Poor's 500 Composite Stock Price Index. The first such models were accounts run by Wells Fargo for its own pension fund and for Illinois Bell.

Presumably fundamental indexes are somewhere in between cap and equal weighting in practicality.

[YogiBear]

I assume that you understand the import of that quote: even for the US, Bernstein finds that there is no statistically significant evidence that the RAFI in and of itself has added any value at all over the S&P 500, other than that added by the 2 Fama-French factors (size and value), which can be accessed through any small-cap or value fund- or get them both at the same time with VBR!

I confess I've forgotten most of my limited knowledge of statistics.

Unfortunately, Canadians have no cheap small-cap value ETF like VBR. Are you saying that, if Bernstein's results were the same in Canada, we could just buy CRQ and somehow, magically, get small-cap value exposure as a bonus?

No, not as a "bonus"- if Bernstein's results were duplicated in the Canadian context, small-cap and (mostly) value exposure is all you would be getting from a fundamental index instrument- because (again, if the results were the same here as he found for the US), there is essentially no other measurable benefit other than that Fama-French factor exposure.

Whether you want to buy such an instrument on that basis is your choice.

It seems to me that the more interesting question is, "Is Arnott's new index fund likely to do better than a regular index fund (pick a value fund if you like) by more than the all-in fee difference?"

If I had a simple, 3 fund equity portfolio - Canadian, US and EAFE large cap index funds, I would pick the RAFI ETFs for the Canadian and US (and EAFE when available) exposure.

On what basis?

[YogiBear]

... The question which is still up in the air, of course, is whether fundamental indexing even "has merit in the US" in fact, as opposed to theory. More importantly for us, AFAIK there has not been any serious testing of the theory in the Canadian context at all, so we are all equally in the dark here!

Yogi: If I may list my thoughts in shorthand as ...
(1) Indexing has merit because it can be both low cost and have broad diversification.
(2) Why is cap-based indexing the norm? I think only because someone, like S&P, started out that way decades ago. I'm not sure it was ever debated on "merit" - like we are imposing on fundamental indexing.
(3) As Arnott points out in his presentation, you would like to have an index that avoids or minimizes the worst extremes of the cap-model for an index. Thus you fold in the other actual numbers, the "doing-business" parameters. That is all to the good in my view.
(4) IF had the choice between two indexes at the SAME MER and roughly the same asset class and diversification, I think I would chose the fundamental over the cap. At present the extra cost in the fundamental index bothers me. (My Vanguard charge for our S&P500 fund is a MER of 9 basis points or 0.09%, as the Admiral rate.)

Shorthand is very good- a lesson I should follow more!

1. ... and (usually) a much lower transaction rate, particularly with broad market indexes, and has no manager risk.
2. See Shakespeare's and Bylo's posts just above. It also, for better or worse, reflects the market's best assessment of value across the entire public float (thus Shakespeare's "psychological" concern, I think ...)
3. Depends on whether you believe Bernstein's numbers- if so, including the '"doing-business" parameters' merely results in a jumped-up value index, presumably because of the sort of parameters one looks for.
4. "the same asset class and diversification" would imply, for the US, mixing the S&P 500 with a large/ mid-cap value fund in some proportion- again, if you accept Bernstein's analysis, that should provide essentially the same thing as the RAFI, at probably less cost (and with the opportunity to carry out profitable re-balancing).

[DenisD]

If I had a simple, 3 fund equity portfolio - Canadian, US and EAFE large cap index funds, I would pick the RAFI ETFs for the Canadian and US (and EAFE when available) exposure.

On what basis?

In the US, I guess it comes down to the long-term back test and comfort with the algorithm. AFAIK, none of the large value ETFs have published a long-term back test. And many (most?) have new algorithms.

So, if I had to pick one large-cap US fund, the RAFI ETF would be my choice. At least, until the O'Shaughnessy ETF arrives!

[IdOp]

The disasterousness of an equal-weighted index lies not so much in the the weightings being equal, but rather in their being constant. Equal weighting is just a special case of that. Constant weightings don't move with the market and need continual rebalancing.

As for the RAFI/CRQ, the promotional material lists some factors that are used to determine the (non-equal) weightings. Some of these are 5-year averages which, while not constant, would change very slowly. To the extent that they do not change, the weightings that depend on them wouldn't change either -- they'd be slowly varying or approximately constant. So important questions would be: How often do they rebalance? Do the weightings change so little as to cause a lot of transaction "disaster"? That's in addition to the 0.65% MER.

I haven't looked into this, but it seems worth getting a handle on. Is it known? The promotional material says turnover is low, but maybe that's compared to an active fund.

[Bylo Selhi]

And for those who still don't believe that mutual funds (and ETFs) are marketed like toothpaste or more aptly, Baskin-Robbins ice cream, with new flavours every month, here's yet more proof. Be sure to check out the snazzy product names like "MagniQuant," "Buyback Achievers" and my favourite, "Autonomic Allocation Research Affiliates" ("this fund will select a currently unnamed number stocks with the best potential for appreciation from within the already performance-selected Intellidex index portfolio. In other words, it will be a market-timing fund within a market-timing fund.")

Massive PowerShares Expansion

PowerShares Capital Management has filed with the Securities and Exchange Commission (SEC) for the right to launch 31 new exchange-traded funds (ETFs), including a full line-up of RAFI-branded ETFs, a host of Intellidex funds and a number of interesting stand-alone portfolios...

The new PowerShares’ RAFI ETFs include one U.S. small/mid-cap ETFs and nine sector-based funds. The new funds are:
PowerShares FTSE RAFI US 1500 Small-Mid Portfolio
PowerShares FTSE RAFI Basic Materials Sector Portfolio
PowerShares FTSE RAFI Industrials Sector Portfolio
PowerShares FTSE RAFI Consumer Goods Sector Portfolio
PowerShares FTSE RAFI Health Care Sector Portfolio
PowerShares FTSE RAFI Consumer Services Sector Portfolio
PowerShares FTSE RAFI Telecommunications Sector Portfolio
PowerShares FTSE RAFI Utilities Sector Portfolio
PowerShares FTSE RAFI Financial Services Sector Portfolio...

The remaining 21 filings cover a wide range of ETFs tied to a number of different strategies. In a list, the new funds are:
PowerShares Dynamic MagniQuant Portfolio
PowerShares Dynamic Large Cap Portfolio
PowerShares Dynamic Mid Cap Portfolio
PowerShares Dynamic Small Cap Portfolio
PowerShares Dynamic Basic Materials Sector Portfolio
PowerShares Dynamic Consumer Discretionary Sector Portfolio
PowerShares Dynamic Consumer Staples Sector Portfolio
PowerShares Dynamic Energy Sector Portfolio
PowerShares Dynamic Financial Sector Portfolio
PowerShares Dynamic Industrials Sector Portfolio
PowerShares Dynamic Healthcare Sector Portfolio
PowerShares Dynamic Technology Sector Portfolio
PowerShares Dynamic Banking Sector Portfolio
PowerShares Dynamic Healthcare Services Sector Portfolio
PowerShares Dynamic Deep Value Portfolio
PowerShares Dynamic Aggressive Growth Portfolio
PowerShares Buyback Achievers™ Portfolio
PowerShares Cleantech™ Portfolio
PowerShares NASDAQ® Dividend Achievers™ Portfolio
PowerShares India Tiger Portfolio
PowerShares Autonomic Allocation Research Affiliates Portfolio...

Of course all of this comes at a price:

One concerning fact about the new ETFs is that they will charge a uniform 70 basis points. Offhand, that is the highest expense ratio I know of for any domestic ETF (and if it’s not the highest, it’s awful close). 70 basis points is getting mighty pricey for an index-linked domestic ETF. The index industry needs to remember John Bogle’s famous maxim: In investing, you get what you don’t pay for.

[NormR]

And for those who still don't believe that mutual funds (and ETFs) are marketed like toothpaste or more aptly, Baskin-Robbins ice cream, with new flavours every month, here's yet more proof. Be sure to check out the snazzy product names like "MagniQuant," "Buyback Achievers" and my favourite, "Autonomic Allocation Research Affiliates" ("this fund will select a currently unnamed number stocks with the best potential for appreciation from within the already performance-selected Intellidex index portfolio. In other words, it will be a market-timing fund within a market-timing fund.")

Gee, you'll soon need an advisor to sort through all the ETFs

[Bylo Selhi]

Gee, you'll soon need an advisor to sort through all the ETFs

I won't

[NormR]

Gee, you'll soon need an advisor to sort through all the ETFs

I won't

But other people will. I'm still waiting for the tulip ETF.

[YogiBear]

And for those who still don't believe that mutual funds (and ETFs) are marketed like toothpaste or more aptly, Baskin-Robbins ice cream, with new flavours every month, here's yet more proof...

Massive PowerShares Expansion

PowerShares Capital Management has filed with the Securities and Exchange Commission (SEC) for the right to launch 31 new exchange-traded funds (ETFs), including a full line-up of RAFI-branded ETFs ...

The new PowerShares’ RAFI ETFs include one U.S. small/mid-cap ETFs and nine sector-based funds. The new funds are:
PowerShares FTSE RAFI US 1500 Small-Mid Portfolio
PowerShares FTSE RAFI Basic Materials Sector Portfolio
PowerShares FTSE RAFI Industrials Sector Portfolio
PowerShares FTSE RAFI Consumer Goods Sector Portfolio
PowerShares FTSE RAFI Health Care Sector Portfolio
PowerShares FTSE RAFI Consumer Services Sector Portfolio
PowerShares FTSE RAFI Telecommunications Sector Portfolio
PowerShares FTSE RAFI Utilities Sector Portfolio
PowerShares FTSE RAFI Financial Services Sector Portfolio

[emphasis added]

Ain't that the truth ... Am I allowed to say "I told you so" ...? (although it was obvious, wasn't it???):

I referred in my first post upthread to "dramatically effective marketing", and that was the feeling one got- fundamental indexing was (and perhaps still is) riding a tidal wave of publicity leading inexorably to product launches.

I'm sure that we're not done milking this wonderful marketing idea for all the product launches that it is worth ...

Gee, you'll soon need an advisor to sort through all the ETFs

I won't

But other people will. I'm still waiting for the tulip ETF. [emphasis added]

Neither will I.

But why stop with a tulip ETF- what about a series of ETFs that would recreate the "best" of each era: a "South Seas" ETF that would hold Canada bonds, with ETF holders having the right to convert other Canadas into new units of the ETF at a discount to the current ETF market price (with all interest payments and the principal at maturity of all holdings going to the sponsor as management fee), or an "Iron Horse" ETF, based on the stocks of companies selling RR right-of-ways and building new lines. Heck, let's even create a "fund-of-funds" ETF that would hold all of the above- we'll call it the "Hindmost" ETF (with aplolgies to E. Chancellor).

Patent pending, of course ...

[Bylo Selhi]

But why stop with a tulip ETF...

Actually I was thinking along the lines of an ETF based on this famous passage from Mackay's Memoirs of Extraordinary Popular Delusions and the Madness of Crowds [Mackay's emphasis]:

But the most absurd and preposterous of all, and which shewed, more completely than any other, the utter madness of the people, was one started by an unknown adventurer, entitled "A company for carrying on an undertaking of great advantage, but nobody to know what it is." Were not the fact stated by scores of credible witnesses, it would be impossible to believe that any person could have been duped by such a project. The man of genius who essayed this bold and successful inroad upon public credulity, merely stated in his prospectus that the required capital was half a million, in five thousand shares of 100l. each, deposit 2l. per share. Each subscriber, paying his deposit, would be entitled to 100l. per annum per share. How this immense profit was to be obtained, he did not condescend to inform them at that time, but promised that in a month full particulars should be duly announced, and a call made for the remaining 98l. of the subscription. Next morning, at nine o'clock, this great man opened an office in Cornhill. Crowds of people beset his door, and when he shut up at three o'clock, he found that no less than one thousand shares had been subscribed for, and the deposits paid. He was thus, in five hours, the winner of 2,000l. He was philosopher enough to be contented with his venture, and set off the same evening for the Continent. He was never heard of again.

[NormR]

But why stop with a tulip ETF...

Actually I was thinking along the lines of an ETF based on this famous passage from Mackay's Memoirs of Extraordinary Popular Delusions and the Madness of Crowds [Mackay's emphasis]:

But the most absurd and preposterous of all, and which shewed, more completely than any other, the utter madness of the people, was one started by an unknown adventurer, entitled "A company for carrying on an undertaking of great advantage, but nobody to know what it is." Were not the fact stated by scores of credible witnesses, it would be impossible to believe that any person could have been duped by such a project. The man of genius who essayed this bold and successful inroad upon public credulity, merely stated in his prospectus that the required capital was half a million, in five thousand shares of 100l. each, deposit 2l. per share. Each subscriber, paying his deposit, would be entitled to 100l. per annum per share. How this immense profit was to be obtained, he did not condescend to inform them at that time, but promised that in a month full particulars should be duly announced, and a call made for the remaining 98l. of the subscription. Next morning, at nine o'clock, this great man opened an office in Cornhill. Crowds of people beset his door, and when he shut up at three o'clock, he found that no less than one thousand shares had been subscribed for, and the deposits paid. He was thus, in five hours, the winner of 2,000l. He was philosopher enough to be contented with his venture, and set off the same evening for the Continent. He was never heard of again.

Um, these days I think that we call them hedge funds

[YogiBear]

... The question which is still up in the air, of course, is whether fundamental indexing even "has merit in the US" in fact, as opposed to theory. More importantly for us, AFAIK there has not been any serious testing of the theory in the Canadian context at all, so we are all equally in the dark here!

Yogi: If I may list my thoughts in shorthand as ...
(1) Indexing has merit because it can be both low cost and have broad diversification.
(2) Why is cap-based indexing the norm? I think only because someone, like S&P, started out that way decades ago. I'm not sure it was ever debated on "merit" - like we are imposing on fundamental indexing.
(3) As Arnott points out in his presentation, you would like to have an index that avoids or minimizes the worst extremes of the cap-model for an index. Thus you fold in the other actual numbers, the "doing-business" parameters. That is all to the good in my view.
(4) IF had the choice between two indexes at the SAME MER and roughly the same asset class and diversification, I think I would chose the fundamental over the cap. At present the extra cost in the fundamental index bothers me. (My Vanguard charge for our S&P500 fund is a MER of 9 basis points or 0.09%, as the Admiral rate.)

George$, you may already be aware of it, but if not, you may want to check out an article posted by Norbert in the thread on "Rob Arnott's Editorials" concerning various approaches to indexing- I have taken the liberty of quoting at length from the discussion on RAFI indexing.

As you will see, several other studies have in fact arrived at essentially the same conclusions as did Bernstein in the article I referred to previously: RAFI is, for all intents and purposes, just a value-tilted index without any discrete, independent source of value-added. (Still no sign of similar Canadian analyses, though ... )

[YogiBear]

Actually I was thinking along the lines of an ETF based on this famous passage from Mackay's Memoirs of Extraordinary Popular Delusions and the Madness of Crowds [Mackay's emphasis]:

But the most absurd and preposterous of all, and which shewed, more completely than any other, the utter madness of the [s]people[/s] money managers, was one started by [s]an unknown adventurer[/s] a former investment banker ... this great man opened an office in [s]Cornhill[/s] Greenwich, Connecticut. Crowds of [s]people[/s] pension funds beset his door, and when he shut up at three o'clock, he found that no less than [s]one thousand shares had been subscribed for, and the deposits paid[/s] $1 billion had been collected ... He was philosopher enough to be contented with his venture, and set off the same evening for the [s]Continent[/s] Carribean. [s]He was never heard of again[/s] Colour photos of his tropical hideaway, paid for with your pension money, have been splashed across the pages of every newsmagazine, encouraging others to try the same thing with every expectation of success.

Um, these days I think that we call them hedge funds

I've updated Mackay's description for the hedge fund world of today ...

[George$]

If I may, I will move the discussion of Arnott's new Fundamental Investing Index back to this thread from the Arnott thread where Yogi posted the following ..

... from 1995 to 2004 ... Moreover, and equally important, its pattern of outperformance and underperformance versus the core indexes follows the same pattern as the value indexes, outperforming when value does well and underperforming when value does poorly

IMO, Arnott would say RAFI underperforms in bubbles such as the late 90's but RAFI outperforms both Value and Blend cap-weighted indexes in normal bull markets.

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.

I believe this is what Bernstein was referring to in his article I referenced in the RAFI thread- that, in effect, not all value indexes are created equal, so to speak. Bernstein used the Fama-French Large Value and Large Growth indexes for his regressions, in order to discount various construction "quirks" that may be inherent to commercial indexes. OTOH, in the article provided by Norbert, which I excerpted above, the authors used the S&P 500/Barra Value and Russell 1000 Value indexes, and the S&P 500 and Russell 1000, for their analyses, and found the same patterns of value-matching performance.

Even if the 1995-2004 timespan used in the article was an exceptional period which would not provide a fair basis for comparison, as you seem to imply, that still leaves the Bernstein analysis, which used a data-set for the period between 1962 and 2004 (RAFI data supplied by Arnott et al, in fact), and which found the results that I've explained at length in the other thread: the "out-performance" of the RAFI 1000 relative to the S&P 500 over that 42 year period was essentially due to its basic (non-fundamental index related) value exposure. That's it. Period. These are the same results as for 1995-2004, notwithstanding anything exceptional about the era: "the RAFI index performance is driven primarily by its implicit value biases" (see my previous post, in section with emphasis added).

Bernstein also suggests that Arnott et al are aware of some potential problems with their claims, and downplay those problems:

While noting that three-factor regression of their indexes had "exposure to the value factor and, to a lesser extent, the size factor," as well as an "estimated alpha of –0.1 percent" (presumably per year), they softpedal the possibility that a large part of the excess return of their fundamental indexes came from exposure to the two "supplemental" Fama-French factors [i.e., value and size], while nodding implicitly to it by observing that other value indexes do even worse, with alphas in the –1.5% range. [emphasis added]

I don't know how many more studies, all by independent researchers using independent sources of data and different bases of comparison and analysis, might be necessary, before there is some acknowledgement that, perhaps, fundamental indexing is not quite all it was sold as. Real debates are good, but that is not what is occurring here. AFAIK, Arnott et al have not explicitely reponded to or refuted the specific findings of the Bernstein, Schoenfeld and Ginis, or Malkiel (referred to by Schoenfeld and Ginis) studies- although the Schoenfeld and Ginis study was just published. If I am wrong, please post a link and a quote. Otherwise, as consistent evidence continues to pile up without refutation or counter-argument that specifically deals with those prior findings, there does not seem much reason to endlessly repeat the same points.

I guess I still don't fully get it. Sorry. It may well be me.

I have again re-read the Bernstein take and I don't fully understand a number of his statements or maybe his analysis.

I will try and organize my thoughts better and post them shortly.

[YogiBear]

I guess I still don't fully get it. Sorry. It may well be me.

I have again re-read the Bernstein take and I don't fully understand a number of his statements or maybe his analysis.

I will try and organize my thoughts better and post them shortly.

It is not you at all, George$. I have read your posts on a number of subjects at this Forum over time, and your insight always comes through. That is why carrying on a discussion with you on this subject was a pleasant prospect.

If I may be so bold, I think the problem is simply one of different frames of reference (I believe that you are a physicist? I may be getting in over my head here re "relative" frames of reference ... ). You seem to have serious concerns about cap-based indexing, and Arnott's ex ante logic about what fundamental indexing should do, and why, appears to offer a solution to those concerns that you find more acceptable than any alternative.

I don't have enough concerns about cap-based indexing that I am a priori interested in alternative indexing approaches, so my starting point is not the claims of Arnott et al, but the ex post analyses of what RAFI has done, relative to various measures. In other words, I am interested in RAFI as a potentially new way of understanding indexing.

This way of seeing our debate may explain why the same points that trouble me (the breakdown of RAFI performance by three-factor analysis, for example) don't bother you- I see RAFI as merely re-mixing known, existing issues (potential value out-performance) while adding nothing new to the debate- and so, therefore, not worth the hoopla. You (and DenisD, I suspect) see RAFI as a way to index certain markets without exposing yourself to the dangers that you feel exist in cap-based indexing- and if that means inherent value exposure, so much the better! The precise source(s) of RAFI out-performance matter a lot less to you than that the approach seems to work.

Does this make sense? I am being analytical, you and DenisD practical- and thus the ongoing nature of our debate?

[George$]

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.
and
Fundamentals-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.

Bernstein write

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

Bernstein:

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.

[YogiBear]

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.

[snip]

In any case my view is that the RAFI approach seems more meaningful - but given the higher MERs perhaps not more desirable.

Oh oh, the classic case of crossing posts- see mine just above yours!

Who shall reply first?

[George$]

... Does this make sense? I am being analytical, you and DenisD practical- and thus the ongoing nature of our debate?

Not sure. Or is it fair to say that perhaps you might be more "bottom line oriented" and I'm more concerned about the reasoning of how one gets to the bottom line.

For example in listening to Arnott's verbal webcast presentation, I was struck by his reminder near the start that only one half of the increase in the GDP is reflected by listed companies in the stock market. Much of the other half of the economic gain arises from the tiny private start-ups - before they go to IPO. This suggests to me that a good fraction of the future gain lies in this sector. Indexes weighted only by cap size marginilze this important component of the economic engine.

Just some musings.

[YogiBear]

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.

...

Further on:

... Does this make sense? I am being analytical, you and DenisD practical- and thus the ongoing nature of our debate?

Not sure. Or is it fair to say that perhaps you might be more "bottom line oriented" and I'm more concerned about the reasoning of how one gets to the bottom line.

...

Thank you for providing additional citations, George$. In order to give your thoughts and sources the attention they deserve, I'm going to take a day or so to look and think, before replying. I seem to have let myself go further down the path of discussing the RAFI in general, instead of merely its application to Canada, than I originally intended ...

[DenisD]

1) Fundantal Indexation by Arnott et al (only abstract - could not find public link to full article)

How about www.indexuniverse.com/docs/Fundamental% ... Arnott.pdf

This may not be the final copy. But I imagine it's close.

[George$]

Thanks Denis and Yogi.

Over at the Morningstar Vanguard they are also discussing Arnott and related.
Conversion 51100 (with 45 postings as I type)