Fundamental indices

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Fundamental indices, developed by Research Affiliates [1] and calculated by FTSE, are known as Research Affiliates Fundamental Index (RAFI). RAFI indices are passively managed market cap indices that use a security weighting system that ranks stocks according to four fundamental value factors. Fundamental indices occupy the Passive security selection/ Fundamental security weighting segnent of the Index Strategy Box (Fig.1).

Fig.1. Index Strategy Box [2]

RAFI indices have also been developed for the bond market, and are calculated in conjunction with Ryan ALM, Inc. [3]

History

Fundamental indexing was developed by Robert Arnott and associates at Research Affiliates, who developed the index security selection and weighting methodologies and researched historical back-tested performance. In 2005, they partnered with index provider FTSE to begin calculating a growing suite of RAFI indices, both for US and international stock markets. The following table shows the historical introduction of RAFI indices.

RAFI Index Inception Dates [4]
Year US Indices International Indices

2005

  • US RAFI 1000 Industry 11/28/2005
  • US RAFI 1000 11/29/2005
  • RAFI Canada 11/28/2005
  • RAFI Developed Ex-US 11/28/2005
  • RAFI Japan 11/28/2005
  • RAFI Europe 12/30/2005

2006

  • US RAFI Mid/Small 1500 5/4/2006
  • RAFI Eurozone 05/04/2006

2007

  • RAFI US 3000 9/17/2007
  • RAFI US 2000 9/17/2007
  • RAFI Real Estate 11/19/2007
  • FTSE/JSE RAFI 40 3/16/2007
  • RAFI Emerging Markets 03/19/2007
  • RAFI Developed Markets 08/06/2007
  • RAFI Ex US Mid/Small 1500 08/06/2007
  • RAFI Developed Asia/Pacific Ex Japan Mid/Small 08/06/2007
  • RAFI Developed Europe Mid/Small 08/06/2007
  • RAFI Kaigai 1000 08/06/2007
  • RAFI Italy 30 11/19/2007
  • RAFI UK 100 11/19/2007
  • RAFI Real Estate 11/19/2007

2008

  • RAFI BRIC 1/28/2008

2009

  • RAFI Australia 8/10/2009

Research Affiliates was granted a patent on the RAFI methodology on November 18, 2009 [5]

In 2010 Research Affiliates laid the methodology groundwork for constructing fundamental bond indices in a paper published in the Journal of Portfolio Management. [6]. On February 10, 2010 Research Affiliates partnered with Ryan ALM, Inc. to construct and calculate a series of RAFI US bond indices. [7]

Characteristics

RAFI Index Construction Rules

"1. The process starts with the selection of the company universes. For the FTSE RAFI US 1000 Index, the constituents of the FTSE US All Cap Index are used, and for the FTSE RAFI Developed ex US 1000 Index the constituents of the FTSE Developed ex US Index are used. The only difference between the two universes is that the FTSE US All Cap Index includes large, medium and small cap companies whereas the FTSE Developed ex US Index consists of only large and mid cap companies. Country indexes fall out of the FTSE RAFI Developed ex US 1000 Index.

2. The universe companies are each ranked by each of the following four fundamental measures of company size: book value, cash flow, sales, and dividends. The percentage weight that each company represents of the total value of each fundamental measure is calculated. Trailing five-year averaged data is used to minimize the substantial volatility in the index factors that would result from using year-to-year data. The five-year averaging also reduces index rebalancing turnover.

3. A composite fundamental value is given to each company by taking the average weighting of each fundamental measure. If a company has a zero dividend percentage the average of the other three metrics are taken. The company’s RAFI fundamental value is defined as 10,000,000 times the composite weight.

4. The companies are then ranked in descending order of their RAFI fundamental values. The top 1000 companies derived from the FTSE US All Cap Index then form the constituents of the FTSE RAFI US 1000 Index. Similarly, the top 1000 companies derived from the FTSE Developed ex US Index then form the constituents of the FTSE RAFI Developed ex US Index.

5. The weights in the indexes are then set proportional to their fundamental values. The weighting factor used in the index calculation is derived by dividing the investable RAFI fundamental value of each company by its free-float adjusted market capitalization. If there are fewer than five years of data available, the average of the years of data that are available are taken. It can be shown that although the results are not materially different from those of their trailing five-year counterparts, portfolio turnover is higher.

6.When converting from company level to stock level factors, the fundamental value is calculated at a company rather than a stock level. If a company has two or more lines of stocks in the relevant index, the company’s fundamental value is allocated between these lines of stock in proportion to the free-float adjusted market capitalizations at the date of the rebalancing."

-- FTSE RAFI Index Series Methodology Overview

Fundamental Indexing is the subject of considerable debate among both investment professionals and individual investors.

Security selection and weighting

The construction of a RAFI index begins with the selection of a company universe (for example the FTSE All US All Cap Index, or the FTSE Developed ex US Index) and a screening process that ranks the companies according to four fundamental valuation factors: sales, cash flow, book value, and dividends (see table below). The selection and weighting process is described in detail in the quote box, RAFI Index Construction Rules.

Fundamental Indexing Weighting Factors [8]
  • Sales = company sales averaged over the prior five years.
  • Cash Flow = company cash flow averaged over the prior five years, defined as Operating Income plus Depreciation.
  • Book Value = company book value at the review date.
  • Dividend = total dividend distributions averaged over the last five years, including both special and regular dividends paid in cash.

Rebalancing and turnover

In order to preserve proper weighting of companies, fundamental indices are rebalanced once a year. The result is that fundamental indices have higher turnover than do comparable asset class market capitalization indices. In terms of implementation, ETF manager Powershares has managed its RAFI funds with much less turnover than mutual fund manager Schwab. [9]

Performance

Debate

Returns

The following tables provide investment returns for two broad-based US RAFI indices that have index tracking funds. Given the value tilt of the RAFI index construction, the return series of comparable Russell market and value indexes is provided for comparison.

RAFI US 1000 Index Returns [10]
Year RAFI 1000 Russell 1000 Russell 1000 Value
2009 +41.98% +28.43% +19.69%
2008 −39.99% −37.60% −36.85%
2007 +3.05% +5.77% −0.17%
2006 +19.68% +15.46% +22.25%
RAFI US 1500 Index Returns [11]
Year RAFI 1500 Russell 2000 Russell 2000 Value
2009 +55.74% +27.17% +20.58%
2008 −38.28% −33.79% −28.92%

The following tables provide investment returns for two broad-based International RAFI indices that have index tracking funds. Given the value tilt of the RAFI index construction, the return series of comparable Russell market and value indexes is provided for comparison.

RAFI Developed Ex-US Index Returns [12]
Year RAFI Dev. Ex-US Russell Dev. Ex-US Russell Dev. Ex-US Value
2009 +44.05% +37.47% +35.68%
2008 −44.19% −42.70%
2007 +12.84% +8.75%
2006 +25.92% +29.35%
RAFI Developed Ex-US Mid/Small Index Returns [13]
Year RAFI Dev. Ex-US Mid/Small Russell Dev. Ex-US Small Russell Ex-US Small Value
2009 +55.74% +47.37% +39.54%
2008 −47.20% −41.90%

Investment options

RAFI Index funds are available from Charles Schwab (mutual funds) and Powershares ( as ETFs). In June, 2011, Powershares expanded its lineup of RAFI indices by changing the benchmarks of seven ETFs formerly tied to Intellidex Indices to RAFI fundamental indices, and by offering two new RAFI ETFs. [14] PIMCO offers four institutional enhanced RAFI index funds.

See also

References

External links

Fundamental index methodologies

Forum discussions

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Articles

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