RAFI fundamental index

The RAFI® (Research Affiliates Fundamental Index®) methodology involves selecting and weighting securities by fundamental measures of company size, as opposed to market capitalization. The methodology captures many of the benefits of passive investing—such as transparency, objectivity, broad economic representation, and diversification—with less exposure to pricing errors and fads.

The RAFI methodology is designed to work in inefficient markets. We believe that prices contain errors and that they revert back to fair value over time. Using fundamental measures of company size, such as sales and dividends, the RAFI methodology represents a company's economic footprint, not constantly shifting market expectations, bubbles and anti-bubbles reflected in its share price.

Cap-weighted indexes are measures of the market, and thus are generally viewed as good benchmarks of market performance. As the basis for an investment strategy, however, cap weighting results in overweighting overpriced securities and underweighting underpriced securities. When the overvalued stocks decline, or when undervalued stocks rebound, Fundamental Index investors benefit. In fact, contra-trading against the market's excesses and speculations is a significant source of added value for the Fundamental Index methodology.

According to our research, the Fundamental Index approach has generated added value of 2% to 4% per year over cap-weighted indexes for large company stocks in developed markets, based on long-term simulations. For less efficient parts of the market, such as emerging market equities, the opportunity to add value is greater. Investors increasingly are seeking exposure to alternative betas such as Fundamental Index strategies to improve the efficiency of their core portfolios.

The methodology also works within a long/short context, taking long positions in companies with large RAFI weights relative to their capitalization weights and short positions in companies with small RAFI weights relative to their capitalization weights. By doing so, this index is designed to generate an absolute return over a full market cycle.

For bonds, the argument is equally compelling. Traditional bond indices tend to give the greatest weight to those companies or countries that issue the largest amount of bonds, with no relation to the issuers' ability to meet those obligations. Why would you load up on obligations from the biggest debtors?

Our research shows that applying the RAFI methodology to U.S. high-yield bonds would have generated more than 2% per annum in added value for the 23-year period ended December 2009. U.S. investment-grade and emerging market debt also would have outperformed traditional indices. The Fundamental Index approach also works well withREITs. 

For equities, long/short, bonds, and REITs, the award-winning Fundamental Index methodology severs the link between price and portfolio weight, reducing the effect of mispricing of securities.

*Tks to Betty, polaris info
Some Taiwan retire fund use this index in Mandate