Category Investments

RAFI passes five-year test with flying colours

11 November 2010 Paul Stewart, managing director at Plexus Asset Management

On a few occasions in my life I have become acutely aware that I am in the company of a special person. A human being destined for greatness on account of extraordinary talents and skills in a particular field.

My first recollection of such an occasion was when I was a 12-year old boy playing in a Junior Golf Foundation tournament at Houghton in Johannesburg. I was watching the group of aspiring golfers teeing off on the first hole, awaiting my allocated time. In the group in front of me, a tall blond boy drove his ball effortlessly down the middle of the lush fairway.

There was something special about his mechanics, but more importantly his demeanour also exuded confidence. I was curious about this highly talented golfer. I went over to the starter and found out from him that the boy’s name was Ernie Els.

I clearly remember feeling a strange combination of intimidation, admiration and also inspiration to try to perform well on the sports field after watching the future superstar strike his golf ball.

I experienced such a feeling at the Research Affiliates symposium, held last week in Newport Beach, California. To be in the company of Rob Arnott and Jason Hsu, Chairman and Chief Investment Officer respectively of Research Affiliates LLC, was utterly intimidating but also inspiring.

Both men possess a potent blend of deep intellect, razor-sharp insights into modern finance, and a vast internal knowledge of economics. This combination of abilities has enabled them to take on the establishment and win respect based on sound logic and ‘complexity-made-simple’ ideas.


It is easy to feel intimidated by their collective brainpower. Fortunately they are really nice guys, who can shoot the breeze with anyone, and especially those who are into mathematical statistics.

They are also special because their ideas and various research papers on fundamental indexation have rocked the academic world of finance since their seminal piece entitled “Fundamental Indexation” was published in the Financial Analysts Journal in 2005.

In a mere six years they have challenged and begun to change the conventional wisdom of finance that has become entrenched over the last 40 years. This is a truly amazing feat in a world of idea snobbery and egotism, which is so characteristic of Ivy League American academia.

The publication of the Research Affiliates Fundamental Index (RAFI) was revolutionary. At its core it challenged the long-held views of how passive indexation should be implemented.

Fundamental Indexation clearly illustrated why the creation of an index that is a function of asset price only – as is the case with market capitalisation-weighted indexation – is inefficient. Arnott and Hsu showed that these indices are not optimal because they structurally misallocate capital over time.

Their conclusions were that cap weighting could be significantly improved upon by employing a methodology that simply estimates the economic value of companies (as opposed to market value) using easily available accounting data, and then weighting the companies in an index accordingly.


Even after demonstrating that over long periods RAFI was able to produce over 2% to 4% per annum outperformance in developed markets, and in excess of 5% per annum in emerging markets, investor response was tepid. Few back-tests ever looked bad, but the career risk of adopting unconventional ideas is large. So the reluctance was understandable.

Detractors argued that RAFI produced its outperformance only by assuming more risk or taking a small-cap value bet – a bias inherent in the types of shares selected by means of the RAFI methodology. But over time RAFI beat most value indices too, so something else was at play.

Certain academics and investment consultants criticised fundamental indexation for not being a passive strategy at all, but merely an active investment strategy disguised as an index. The debate has raged on and has often been characterised by harsh words and unfair criticism by critics of RAFI. Despite this, Arnott, Hsu and their fellow research team kept their faith.

Now, with five years of real-life money returns around the world in various capital markets, Research Affiliates has earned the right to become forthright about its critics. Actual developed-market returns of RAFI versus respective market cap-weighted indices are very close to the simulated back-tested results. Outperformance across the board and information and Sharpe ratios of RAFI are exceptional. The critics have been silenced.

Over US$43 billion has now flowed into various RAFI strategies globally. Perhaps the time has come for those who are still non-believers to seriously look at their anxieties and act to understand or eradicate them.

As a RAFI practitioner in South Africa I am regularly asked whether RAFI is an active or passive investment. It seems the Research Affiliates team is regularly asked this question too. Arnott simply says: “We really don’t care by what name you want to call it, or into which box you wish to put RAFI. Just know that it works.”

So whether you are an active fund blender, a core satellite proponent or a pure passive investor, RAFI has application for you and your clients. Quite simply, RAFI over a full six- to eight-year business cycle is a more efficient means of extracting the beta of the equity market than cap weighting. The fact that it also beats many of the brand-name fund managers is a by-product of RAFI’s efficient stock selection process and its lower cost base.

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