Some information on RAFI exchange traded funds (ETFs)

The good showing in performance surveys by RAFI based ETFs has raised some interest about the exact nature and constituents of such products.

RAFI stands for “Research Affiliates Fundamental Indexation”. Research Affiliates is a California USA based financial services company that has registered worldwide the patent for fundamental indexation, which ranks companies based on a specific formula devised by this company. Unless you have a license agreement with Research Affiliates, you cannot use the words “fundamental indexation” in any investment products. In South Africa, FTSE/JSE, who develop indices for the local stockmarket and Plexus Asset Management have entered into such license agreements.

The local RAFI indices are based on a 5 year Survey of the accounting data of the Top 100 companies on the JSE. The RAFI methodology ranks and weights such shares based on fundamental valuation metric, namely sales, cash flows, book prices and dividends. An index is constituted of 40 of the top 100 local companies based on this fundamental metric method. In the enhanced fundamental indexation method, for which Plexus has the local license, two additional filters are added to the valuation technology, namely the quality of earnings and financial distress.

RAFI products differ from normal market capitalisation indices as they do not rely on size, performance and liquidity to assess the shares that appear in an index, but purely gauge index constituent shares based on their fundamental accounting value. By identifying shares which offer value, a RAFI portfolio could be expected, over time, to offer better performance than a normal market cap index product. As such, they should be viewed in the same context as a “value fund”.

However, the RAFI index is only adjusted periodically - annually in the case of the FTSE/JSE RAFI license - and quarterly in the case of the enhanced RAFI products. The portfolio churn, which can characterise an actively managed value fund, is largely absent with the ETF RAFI products, which helps keep down their costs.

The following RAFI products are currently available in South Africa.

The Plexus/etfSA Quarterly Performance Survey for September 2010 shows that the various RAFI funds have comfortably outperformed their benchmarks as well as the average return of the general unit trust industry over the past three years, which suggests that the RAFI technology does provide an alpha alternative.