| Wednesday, 16 July 2008 08:16 | |
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The current credit shake-up began one year ago, with Bear Stearns revealing large losses incurred in its two subprime-heavy hedge funds. Since that time, RAFI® equity applications have delivered mixed results with generally sound performance overseas—especially relative to the conventional capitalization-weighted value indexes—and shortfalls in the United States. In light of these mixed results, we examine the Fundamental Index® approach in previous difficult credit and liquidity periods and explore some attribution of the recent shortfall in the United States. While recent times have been disappointing for some cases, this exploration suggests the Fundamental Index concept remains as valid as ever. Indeed, in most markets outside of the United States, RAFI has performed admirably in the face of a hurricane-force headwind—that is, growth sharply outpacing value. Since the credit crunch started, growth stocks have ripped market leadership away from value in a startling fashion all over the world. Figure 1 displays the excess returns of value over growth across five major equity categories. Only emerging markets witnessed value outperformance. Growth dominated by 700-1,200 bps in the remaining asset classes. It was an historic and global run—the past 12 months were the third-worst year of performance (using rolling quarterly observations) for EAFE Value versus EAFE Growth since 1970. Given that these 131 rolling one-year periods cover 38 years, this implies a 40-year storm for international value investors!
Amidst this environment, RAFI applications have witnessed a range of excess returns versus their cap-weighted counterparts. As Table 1 shows, the results in the less-efficient markets (emerging markets and non-U.S. small company) added value, while those in the most-efficient markets (developed large—both U.S. and developed ex-U.S.—and U.S. small-mid) trailed their respective benchmarks for the 12 months ending June 30, 2008.
The modest shortfall in U.S. small companies and developed ex-U.S. large companies is well within the projected range of relative performance compared with cap-weighted indexes, particularly given the vast underperformance of value in these domains. In fact, our research suggests that we would expect to incur these types of results once every six or seven years.[1] The recent underperformance in U.S. large companies, however, is somewhat larger than our research suggests is normal, even given the magnitude of the underperformance by the cap-weighted value indexes. Figure 2 plots the RAFI U.S. large company rolling one-year excess returns. The past 12 months' relative return is pretty far to the left of the distribution, suggesting something on the order of a 1-in-15-years event. Let's explore why.
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RAFI In Down Markets
The recent relative underperformance has come during a period of negative returns in the equity market—a time when our research has shown that the Fundamental Index methodology tends to excel. Part of the explanation is that over the past 12 months, low-multiple companies and value sectors have significantly underperformed, which is quite rare in bear markets.
Recall, capitalization weighting places a greater emphasis on the perceived future growth of a company; thus, expected future growers will have a higher allocation. Meanwhile, slower growers, weighted by current economic scale, will have a higher relative weight in the Fundamental Index portfolio. For this reason, on average, the RAFI strategy has an inherent value tilt relative to cap-weighted indexes, exactly mirroring the market's growth bias relative to the broad economy.
In most down economic periods and bear markets, it is well-documented that value outperforms growth, especially in the late stages of a bear market! Liquidity is still available, and financing costs for leveraged borrowers typically stay the same on a nominal basis—spreads rise, but this is typically because government bond yields fall. Likewise, commodity prices tend to drop as slowing aggregate demand leads to reduced raw goods consumption. Thus, the slower growers, capital-intensive and financially leveraged companies often typical of RAFI overweights, can weather these more-conventional storms in relatively good shape. However, higher expected growers that are "priced to perfection" get routinely punished, as the Nifty Fifty of the early 1970s and the Tech Bubble of the late 1990s clearly demonstrate. And so, the reason that the RAFI approach wins, on average, in down markets is that the high-multiple companies get severely punished as the rosy economic outlook that justifies their elevated P/E ratios fails to materialize.
The past 12 months has been an exception to this rule: Low-multiple companies and value sectors underperformed significantly. Many of these firms suffered against the headwinds of rising yield spreads and commodity prices, whereas many of the growth companies have been able to withstand these strong headwinds ... so far.
The Impact Of Rebalancing
A significant contributor to recent FTSE RAFI US 1000 underperformance is that the index was reconstituted in March 2008. In hindsight, second-quarter returns would have been better by 2.3 percentage points (pps) without the rebalance. In fact, the most recent rebalance finally moved the RAFI portfolio to a moderate overweight stance in financials (before the March 2008 rebalance, we were only 1% above the cap weight, despite our inherent value tilt!). We have long advocated that one of the chief benefits of the Fundamental Index approach is the manner in which it contratrades against recent market trends by rebalancing company prices back to fundamentals. In so doing, a Fundamental Index portfolio will contratrade against style fads and crashes, sector fads and crashes, and even individual company fads and crashes.
Just as most practitioners believe that rebalancing our asset allocation is a powerful tool in our investing tool kit, a Fundamental Index portfolio rebalances within our equity holdings. However, rebalancing can sometimes be a shorter-term detractor from portfolio performance when market trends—positive or negative—persist. For example, rebalancing away from technology and other high-flying growth stocks—especially those with negligible sales and no profits—in the late 1990s left relative gains on the table for a period of time. Rebalancing did pay off, however, once gravity finally took over and the emerging growth shares crashed back to Earth.
On the opposite end, rebalancing into stocks (or asset classes) that continue to underperform will also cause short-term disappointment. This is exactly what occurred with the FTSE RAFI US 1000 and other valuation-indifferent indexes in March 2008. As an example, the FTSE RAFI US 1000 held 18.8% in financials prior to the March rebalance and 25.2% subsequently. Given that financials declined 18.3% from the end of March through June 30, this cost us over 100 bps in returns versus a portfolio that bypassed reconstitution. Similarly, rebalancing away from energy cost nearly 50 bps during the quarter. In our minds, this is more of a rebalancing timeliness issue than an indictment of the Fundamental Index strategy. Indeed, it's hard to find an investment professional who doesn't advocate rebalancing as a fundamental (pardon the pun) investment activity.
Changes At The Top
With all the movement in the market, it is fascinating to note the changes in the top 10 companies—both in terms of names and weights. As Table 2 shows, there is a compression in the fundamental size measures as of June 30, 2008. Note also that the overlap on these two lists is now down to only six companies (it was eight at March 2007 rebalance), and financials occupy zero spots in the S&P top 10 (indeed not a single one of the top 15!) at this stage. Citigroup, JPMorgan Chase, Wal-Mart and Verizon are all huge, but the market doesn't think their future prospects deserve a top 10 ranking. Reciprocally, the market believes that Procter & Gamble, Johnson & Johnson, IBM and Apple will all be a more important part of our future economy than the four out-of-favor names, even though none of these four ranks in the top 10 based on the current scale of their enterprises. Even if the market is right about most of these, it still means that the RAFI strategy can add value in the one or two whose prospects are underestimated and the corresponding one or two on the list whose prospects are overstated.
Will some financials fall much further? Probably. Could the sector, collectively, fall more? Of course. Does it make sense that none of them—not one—ranks in the top 15 by market cap? We're not so sure about that! This rout in the financial services sector—the largest sector of the U.S. economy—bears all the trappings of an "anti-bubble," a runaway speculative avoidance of anything in the sector. We think this is a terrific opportunity to shift from the "active bets" of capitalization weighting to the economic bets of the Fundamental Index concept!
Lessons From The Past
It is worth noting that the past 12 months is atypical—but not without historical precedent. Let's review a few facts related to 1990—a similar environment to the past 12 months.
In 1990, the S&P 500 suffered a 3.1% decline, with the FTSE RAFI US 1000 posting an 8.9% loss, a deficit similar to the past 12 months. Additional comparisons between the two years are presented in Table 3.
Several trends from 1990 are worth noting as they relate to today:
- Not surprisingly, financials suffered badly in 1990, as bad loans and deleveraging impacted bank balance sheets. In 1990, financials trailed the S&P 500 by 17.7 pps as compared with a similar deficit of 29 pps in the trailing 12 months ended June 30, 2008. Both periods saw financials finish dead last among the major economic sectors.
- As they have in the past year, commodities rallied strongly in 1990 with the Goldman Sachs Commodity Index surging 29.1% after Saddam Hussein and Iraq invaded Kuwait, causing a significant spike in oil prices. However, this run-up in raw inputs paled in comparison to the 76% rise in the GSCI over the past 12 months.
- Credit was a major issue in 1990, as conditions rapidly deteriorated on the heels of the American savings & loan crisis. High-yield (corporate bonds rated below investment grade) spreads above government bonds spiked by 510 bps in 1990, indicating rising risk aversion on the part of lenders. Similarly, we have witnessed high-yield spreads jump from 440 bps from June 2007 through June 2008.
- Growth trounced value by roughly 800 bps as measured by the Russell 1000 Growth versus the Russell 1000 Value in 1990. Over the latest 12 months, growth outperformed value by nearly 1,300 bps.
Perhaps most important to investors and for the historically inclined, after the poor performance of 1990, the FTSE RAFI US 1000 Index went on to produce a five-year annualized return of 19.2% versus 16.6% for the S&P 500—an excess return of 2.6% pps per annum—bettering the 2.1% experienced over our originally tested 1962-2004 time horizon.[2] As seen in Table 4, this also doubled the incremental return of value during this period. Of course, it wasn't a linear ride each and every year above the S&P 500. Growth again surged in 1991, actually outpacing value by 1,600 bps—its third-best year ever since the inception of the Russell indices, exceeded only by the bubble-induced 1998 and 1999. Despite this massive growth headwind, the Fundamental Index portfolio finished relatively flat in 1991, but then went on to produce reasonable excess returns in the ensuing four years.
Conclusion
Mark Twain once quipped, "History doesn't repeat itself, but it does rhyme." We don't expect history to repeat exactly, but we do believe the Fundamental Index approach will weather the storm of 2007-2008 much as it has in the past. The return drag from capitalization weighting—overweighting overpriced securities and underweighting underpriced securities—is a structural long-term return inhibitor. Over shorter intervals, any Fundamental Index application may underperform by placing proportionately more in underperforming stocks than its cap-weighted counterpart. The same can be said for equal weighting or, for that matter, any other price-indifferent strategy. After all, the goal of price-indifferent indexing is to randomize portfolio weights to approximately allocate half of our money to overvalued shares and half to the undervalued.
We know that capitalization weighting will structurally place more in securities whose stocks are priced above fair value and less in those that are priced below fair value. Why? Because the weights relative to fair value are not random; they are linked to price and the errors embedded within that price! For this reason, Fundamental Index supporters—if they had existed in December 1990—would have been confident about the future prospects of the RAFI methodology, just as we are today.
1. Both RAFI Global ex-U.S. and RAFI U.S. Small Company have approximate historical, backtested excess returns of 3.4% with tracking errors of 4% through 2007. This covers 1979 for RAFI U.S. Small Company and 1984 for RAFI Global ex-US.
2. Arnott, Robert D., Jason Hsu, and Philip Moore. 2005. "Fundamental Indexation." Financial Analysts Journal, vol. 61, no. 2. (March/April): 83-99.
© Research Affiliates®, LLC 2008. The material contained in this newsletter is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any securities transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. Neither Robert D. Arnott nor Research Affiliates and its related entities warrants the accuracy of the information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this newsletter is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this newsletter should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
ROBERT ARNOTT, Chairman and Founder of Research Affiliates, LLC.
JOHN WEST, CFA, Associate Director, Marketing & Affiliate Relations of Research Affiliates, LLC
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