A Better Fundamental Index

A version of this article was published in the September 2013 issue of Morningstar ETFInvestor. Download a complimentary copy here.

On Aug. 15, 2013, Schwab launched six funds based on the Research Affiliates Fundamental Index, or RAFI, methodology. Fundamental indexes weight stocks by a measure of economic size such as revenues, earnings, and so on, or a combination of such measures. This lends them a value tilt, which historically has generated excess returns in most markets studied. (The excess return is called the value premium.)

When fundamental indexes first came out, academics were quick to point out investable value-tilted index funds have been around for decades. However, traditional value indexes simply sort stocks into value or growth buckets and market-weight individual stocks, diluting their tilt. Moreover, they often define value and growth segments as having equal aggregate market shares, further attenuating any value exposure. The fundamental index ignores such niceties. In terms of purity, it's clearly superior to more traditional offerings, which were intended as style benchmarks rather than attempts to beat the market.

The long-standing problem with fundamental index funds (as with other newfangled strategies) has been cost. Sure, they may be better, but when they first came out, sponsors charged near-active-management fees. Things got ugly; traditional index-fund advocates called fundamental indexes "active management in drag." They may be, but Schwab's new funds charge more-than-reasonable fees. And in the tradition of exchange-traded fund innovation, they're cheaper than many competitors.

Source: Morningstar Analysts.

The new Schwab offerings undercut PowerShares' lineup of FTSE RAFI funds from 3 to 12 basis points and Schwab's pre-existing lineup of Russell Fundamental Index mutual funds by about 3 basis points.

They aren't the cheapest fundamental indexes, however. The recently launched iShares MSCI USA Value Factor (VLUE), which tracks a knockoff of the RAFI, charges a 0.15% expense ratio. WisdomTree's dividend- and earnings-weighted ETFs are also cheaper.

I like the Schwab funds more than iShares' MSCI fundamental index fund because they delve into smaller securities, which historically have generated most of the value premium. I also prefer the RAFI's use of multiple valuation metrics over WisdomTree's reliance on either dividends or earnings, as multiple metrics can cancel out some of the idiosyncratic noise attributable to a single metric, thereby producing cleaner exposure to the value factor.

Russell has had the benefit of time to tweak the fundamental index methodology to improve upon Rob Arnott's original formulation. Russell uses three factors to calculate each stock's fundamental weighting:

1) Leverage-adjusted sales, calculated by averaging five years of sales and multiplying it by an adjustment factor of average equity to average assets. This penalizes firms that use lots of leverage and don't generate commensurate revenues. It screens out distressed firms or firms more susceptible to distress.

2) Retained operating cash flow, calculated by averaging five years of operating cash flow from operations minus dividends and buybacks. This isn't much different from operating cash flow, but Russell wanted to avoid double-weighting dividends and buybacks, which are the third factor.

3) Dividends plus buybacks, averaged over five years. Dividends, while still the most visible way corporations return cash to shareholders, have become increasingly supplanted by share repurchases, which are more tax-efficient and (unfortunately) don't saddle managers with the expectation that they'll continue. Researchers have found that more comprehensive measures of shareholder cash payouts are better predictors of future returns than dividends alone.

All three metrics are sensible in isolation and likely better than the traditional RAFI factors (five-year averages of dividends, sales, and cash flow, and latest book value) as indicators of value.

Another improvement that I've long desired in the traditional RAFI is the implementation of staggered quarterly rebalances. The FTSE RAFI, for example, follows the original RAFI methodology closely and rebalances each March in one fell swoop. It's not a minor detail. The RAFI tends to favor less-liquid, smaller stocks and has historically generated a decent portion of its returns from them.

We can see this effect by comparing the back-tested returns of the FTSE RAFI US 1000 Index and the MSCI USA Value-Weighted Index. MSCI's clients tend to be big institutions, so the firm hews to liquid parts of the market. As of this writing, the smallest stock's market value in the FTSE RAFI 1000 is a little more than $1.0 billion; in the MSCI USA Value-Weighted Index, it's about $3.6 billion. The different liquidity and size cutoffs have resulted in a 1.5-percentage-point difference in annualized returns since each index's common back-tested inception date.

Source: Morningstar Analysts.

The Russell indexes can dip pretty deep down into less-liquid small-cap stocks. For instance, the "large-cap" version of the fund owns stocks with market caps as small as $750 million. The small-cap version dips into a fair number of micro-caps, the smallest being under $200 million. Judging by these numbers, the Russell RAFI has the potential to pack quite a punch.

However, the impressive excess returns generated by the small fry can turn into equally impressive negative returns when a flood of money rushes in and out of them heedless of valuation.[1] The widely followed Russell 2000 Index is notorious for lagging other small-cap indexes, largely because the stocks that it adds and deletes experience tremendous market pressure relative to the stocks' liquidity. Deleted stocks are sold en masse on the same day by funds tracking the Russell 2000, lowering prices. Added stocks are bought en masse, raising prices. Studies have put the Russell 2000's historical index turnover cost at 0.4% to 1.8% annually (through it's probably lower today, after Russell made some changes).[2] (In case you're wondering, the small-cap Russell fundamental indexes aren't tied to the Russell 2000.)

In anticipation of these problems, the Russell fundamental index spreads its rebalances over the year to reduce market impact. The index operates as if it were divided into four independent portfolios (which initially are identical), and each portfolio is rebalanced in a different quarter. Additions are introduced over the year, but deletions are kicked out immediately.

These methodology changes collectively add up to a better RAFI. The lower fee is the cherry on top.

1) Petajisto, Antti. 2011. "The Index Premium and Its Hidden Cost for Index Funds." Journal of Empirical Finance, vol. 18: 271-288.

2) Chen, Honghui and Noronha, Gregory and Singal, Vijay. 2005. "Index Changes and Unexpected Losses to Investors in S&P 500 and Russell 2000 Index Funds." Working Paper (March).

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