By: Catherine Yoshimoto, Senior Index Product Manager
Over the 12 months ending September 30, 2015, an estimated $96 billion USD in net flows have gone into “smart beta” ETF products, with $584 billion in total assets invested in smart beta ETFs as of September 2015.1 With the market’s current enthusiasm for smart beta ETFs comes an increased interest in smart beta indexes, so it is essential to understand how the different construction of smart beta indexes affects their performance vis-à-vis market cap-weighted indexes.
In recent years, indexes based on the Fundamental Index™ concept have not performed as well as growth indexes, but over a longer period that has not been the case, and the reasons explain a lot about how a Fundamental Index works. For some, investments in smart beta ETFs tracking Fundamental Indexes may provide an important component for their investment portfolios.2
The Fundamental Index pioneered by Research Affiliates is based on Graham and Dodd’s economy-centric view that while markets are constantly seeking fair value, prices are rarely right. The market itself makes estimates and some companies can get overpriced, while others can get underpriced.
FTSE Russell offers two headline Fundamental Index families, which are alternatively-weighted indexes with broad investment capacity of the underlying index constituents: FTSE RAFI™ and Russell Fundamental Index. Both index series seek to break the link between a stock’s price and its weight in the index. Both the FTSE RAFI and Russell Fundamental Index methodologies rank and weight companies based on fundamental measures of company size:
- The FTSE RAFI series uses sales, cash flow, dividends and book value.
- The Russell Fundamental Index series uses dividends + buybacks, retained operating cash flow and adjusted sales. Relative to the FTSE RAFI methodology, the Russell Fundamental Index series applies smaller weights to more highly-levered companies. This is due to the adjusted sales factor, which effectively lowers the sales measure by the level of a company’s debt.
In addition, quarterly implementation of the FTSE RAFI QSR series as well as the Russell Fundamental Index family minimizes the risk of a single annual entry point, increases capacity and systematically reviews the index constituents so that overvalued stocks are replaced with undervalued stocks. The resulting Fundamental Indexes have delivered index performance in excess of the market-cap weighted index over the long term, as further detailed below.3
The following examples show the historical performance of the U.S. large cap FTSE RAFI and Russell Fundamental Indexes relative to the performance of the market-cap weighted Russell 1000 (R1), the Russell 1000 Value Index (R1V) and the Russell 1000 Growth Index (R1G).
First of all, then, how does the Fundamental Index perform when the Value Index outperforms the Growth Index? At times, the performance of the Fundamental Index has aligned with that of the Value Index, such as the R1V. Indeed, in periods when the R1V outperformed the R1G over six or seven consecutive months, both the Russell Fundamental U.S. Large Company (RFUSLC) Index and FTSE RAFI US 1000 (FRUS1000) Index also outperformed the R1G as well as the R1.
Conversely, how does the Fundamental Index perform when the Growth Index outperforms the Value Index? In contrast to the first example, when the R1G outperformed the R1V over two seven-month periods, the performance of both the RFUSLC and FRUS1000 lagged that of the R1G and the R1, though not to the extent of the R1V. It's worth noting that the R1G has outperformed the R1V for the majority of the past 5 years during which the markets have recovered from the Global Financial Crisis, and the performance of the R1G may seem more attractive than that of the RFUSCL and FRUS1000 or R1V Indexes during times like this. However, over the past 19 years, the number of months over which the R1G outperformed the R1V has been roughly the same as the number of months over which the R1V outperformed the R1G (113 vs. 115).
Over the long-term, the Fundamental Index has outperformed the market cap-weighted index.Historical evidence shows that Fundamental Indexes perform well when value stocks do well, and that over the longer-term, the Fundamental Indexes have outperformed both Growth and Value Indexes. A growth of $100 chart shows that both RFUSLC and FRUS1000 outperformed the R1, R1G and R1V from June 30, 1996 through June 30, 2015.
This longer-term performance illustrates the benefit of regular rebalancing and diversification of risk over varying market cycles that are features of the Fundamental Index. Rebalancing into less popular or undervalued stocks and out of the most popular or overvalued stocks—what Research Affiliates calls “contra trading”—has historically provided the majority of the Fundamental Index’s added value. The Fundamental Index has a dynamic value tilt, which means that when value stocks are out of favor and thus are undervalued, the Fundamental Index has an increased allocation to deep value stocks; however, the value tilt is milder when value stocks are in favor and thus priced higher. This has contributed to the higher performance of the Fundamental Index over the market cap weighted index over the 19 years ended June 30, 2015.
For additional insights into Fundamental Indexes, read the full research.
 Morningstar Direct, September 30, 2015. Estimated share class net flows and net assets for Strategic Beta ETF products.
 Indexes are unmanaged and cannot be invested in directly. Past performance is not a guarantee of future results.
 The inception date of the Russell Fundamental US Large Company Index is February 24, 2011. The inception date of the FTSE RAFI US 1000 Index is November 28, 2005. Returns provided for each FTSE Russell Index may include data for periods prior to when each FTSE Russell Index was in live production. Hypothetical historical returns for these FTSE Russell indexes prior to the live production date are calculated using the same FTSE Russell methodology; however, application to the performance calculation may vary due to data sources, corporate actions and the availability of historical data with respect to certain securities.
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