In late 2005, PowerShares launched an ETF (ticker symbol: PRF) based on a controversial new \u201cindex\u201d known as the Research Affiliates Fundamental 1000 Index (RAFI 1000).\u00a0\u00a0 We now have over 5 years of return data for this fund, and this seems to me to be enough data for us to take a preliminary look at the strategy\u2019s performance.\u00a0<\/p>\n
A quick comparison of PRF against popular traditional index funds such as SPY and VTI is shown below.\u00a0 This plot shows total returns (including dividends).<\/p>\n
This graph shows that PRF has outperformed both SPY and VTI over the past 5 years, but it also experienced a larger drop during the crisis of 2008 and 2009. \u00a0To properly evaluate the performance of PRF, we need adjust the returns for risk using an asset pricing model such as the Fama-French Three Factor Model (FF3F).\u00a0 However, before I get to the detailed analysis, I\u2019d like to review what Fundamental Indexing is and why it is controversial.<\/p>\n What is Fundamental Indexing?<\/strong><\/p>\n Fundamental Indexing is an alternative method for constructing a stock index.\u00a0<\/p>\n Traditional indexes weight stocks based on market capitalization.\u00a0 Stocks with greater market capitalization are given a greater weight in the index.\u00a0 For example, Exxon-Mobil has over 10 times the market capitalization of Target, so Exxon-Mobil has 10 times as much weight in capitalization weighted indexes such as the S&P500 or Wilshire5000.\u00a0\u00a0<\/p>\n Fundamental indexes weight the stocks in the index using size related factors which are not tied to market price.\u00a0 For example, metrics such as book value, revenue, dividends, etc. are used to determine the weights of the stocks in the index.\u00a0<\/p>\n Proponents of Fundamental Indexing believe that their method of weighting stocks is superior because they believe that there is overpricing and underpricing in the market which investors correct over time.\u00a0 Traditional indexes, by construction, will overweight overvalued funds and underweight undervalued funds.\u00a0 When the mispricing of these stocks is eventually corrected, it creates a \u201cstructural drag\u201d on the returns of the index.\u00a0 Fundamental Index advocates do not claim to be able to identify these underpriced and overpriced stocks in advance, but they do believe that their method of indexing will randomize the valuation errors in a way that capitalization weighting cannot.<\/p>\n The most well known proponents of Fundamental Indexing are Robert Arnott, Jason Hsu, and\u00a0Phillip Moore\u00a0who wrote one of the first papers<\/a> on the strategy back in 2005.\u00a0 Arnott is the founder of Research Affiliates.<\/p>\n Why is Fundamental Indexing controversial?<\/strong><\/p>\n Fundamental Indexing has been criticized by traditional index advocates who believe that it is not true indexing and that weighting stocks by fundamentals constitutes an \u201cactive\u201d bet away from the market portfolio.\u00a0 These critics also note that Fundamental Indexing is likely to have higher costs than traditional indexing because more trading is required to keep portfolio weights in line with the model.\u00a0 Prominent critics from this school of thought are John Bogle and Burton Malkiel.\u00a0 \u00a0Their 2006 WSJ critique of Fundamental Indexing can be read here<\/a>.<\/p>\n Other critics of Fundamental Indexing believe that weighting stocks by fundamentals is really just value investing.\u00a0 They say that any outperformance of Fundamental Index portfolios is due to the \u201cvalue tilt\u201d that is inherent in a system that weights stocks by fundamental factors.\u00a0 Prominent critics from this school of thought include Eugene Fama, Kenneth French, and Cliff Asness.\u00a0 \u00a0Fama and French discussed Fundamental Indexing in a interview which is available here<\/a>.<\/p>\n How has Fundamental Indexing performed so far?\u00a0 <\/strong><\/p>\n As shown above, Fundamental Indexing has outperformed the S&P500 and the Wilshire 5000 over the past 5 years.\u00a0 However, we need to adjust the returns for risk, and one common method for making this adjustment is the Fama-French 3 Factor model.\u00a0<\/p>\n I ran the Fama-French regressions on a number of more traditionally constructed\u00a0index funds, and I found a couple that were reasonably close matches to PRF\u00a0in terms of\u00a0FF3F loading.\u00a0 IWD is an ETF based on the Russell 1000 Value Index, and IWW is an ETF based on the Russell 3000 Value Index.\u00a0 Both of these funds have a slightly lower value loading than PRF, but they are generally quite similar.\u00a0<\/p>\n The results of the FF3F regressions using 5 years of monthly return data for\u00a0these three funds are\u00a0shown here:<\/p>\n\n![\"\"](\"http:\/\/www.calculatinginvestor.com\/wp-content\/uploads\/2011\/01\/traditionalvsfundamental-e1296415039980.png\" "\\"traditionalvsfundamental\\"")
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