Fundamental index backer responds
The July 23 Pension & Investments published an article on page 6 about Research Affiliates’ Fundamental Index strategies, referencing the Wilshire Associates white paper “Fundamentally Active” by Robert Waid.
We have little substantive disagreement with many of Mr. Waid’s points, including his perspective that RAFI is not passive and is not an index. This is a matter of semantics: if we define “passive” or “index” to mean cap-weighted, then the RAFI strategy is not an index.
Further, Mr. Waid argues that alternatively weighted indexes, which include RAFI strategies, don’t offer a gauge on how the market is performing. Markets are indeed cap-weighted and cap-weighting is the right way to measure the performance of markets, though not necessarily the performance of the “average stock.”
Mr. Waid also indicates that investment strategies using fundamental metrics to measure the size of a firm are a form of value and small-cap investing. We agree that relative to cap-weighting, RAFI strategies will always have a value tilt and at times will have a size tilt. We also believe, however, that a cap-weighted portfolio, relative to the size-weighted average company in the economy, will always have a growth tilt.
More substantively, many of Mr. Waid’s criticisms relate to the following points (and our rebuttal):
• The RAFI concept is not structurally better than cap-weighting. We believe the RAFI concept is structurally superior because markets are not perfectly efficient — that is, stock prices are estimates of fair value, with errors roughly randomly distributed around fair value. Given pricing errors, a cap-weighted strategy will structurally overweight overvalued stocks and underweight undervalued stocks, leading to a performance drag of two to three percentage points. Of course, RAFI strategies will not outperform every year; however, over a long horizon, we are confident that this structural advantage will prevail.
• RAFI strategies are not a better measure of a company’s true value. Of course not! We do not claim to know the “right” weight, or whether a stock is over- or undervalued. Linking price to the portfolio weights, as cap-weighting does, creates a structural performance drag, relative to the investible opportunity set, which the fundamental approach largely neutralizes.
• RAFI strategies are just a value play. Relative to cap-weighting, RAFI strategies are a value play — but RAFI is more than that. Just as cap-weighting loads up on growth companies relative to their footprint in the economy, RAFI strategies load up on value stocks relative to their footprint in the stock market. One-fourth of the 2.2 percentage-point RAFI advantage can be attributed to its average value tilt. The remaining three-fourths of the value-added comes from dynamic shifts in the RAFI tilts.
• RAFI advantages will disappear if enough money moves from cap-weighting to RAFI strategies. We agree but think it will be years before any meaningful capacity constraint is reached. Currently, about $5 trillion is indexed worldwide. If 20% of this sum — or about $1 trillion — shifted to RAFI investing, RAFI portfolios would comprise only 2% of world equities.
An example of the power of RAFI strategies is seen this year. Through July, the Russell 1000 Growth index led the Russell 1000 Value index by over 500 basis points, an environment in which a value-tilt strategy should significantly underperform, yet the FTSE RAFI US 1000 has kept pace with the S&P 500 index.
ROBERT D. ARNOTT
chairman, Research Affiliates LLC
Pasadena, Calif.
Praising stable value
I am writing on behalf of the Stable Value Investment Association in response to the Aug. 6 editorial titled, “Default for Growth.” The editorial assumes “some investment service providers are going to be disappointed” if the Department of Labor’s safe harbor for auto-enrollment and auto-invested funds excludes stable value funds.
The issue is not whether stable value providers will be disappointed, but the inevitable disappointment of the many plan participants who will be defaulted into the proposed safe harbor investments if stable value is excluded as a safe harbor default.
Your editorial missed the point about the safe harbor and stable value. Certain employee populations are risk averse and have investment horizons of short or unknown duration. These populations tend to be lower paid, shorter-tenured employees and older workers close to retirement. These populations do not have the risk tolerance associated with target-date funds or the time to recoup investment losses and to achieve the “higher returns” promised under your scenario of “default for growth.”
Stable value funds offer a cost-effective, competitive risk-adjusted return while focusing primarily on capital preservation and providing returns similar to intermediate bonds without the volatility. Including stable value funds in the safe harbor broadens the array of qualified investment defaults to include a vehicle that focuses exclusively on capital preservation that not only fulfills the legislative mandate for such a vehicle but also recognizes the broad support for stable value as a safe harbor among plan sponsor groups, participant groups and unions.
Most importantly, including stable value as a safe harbor provides a safety net for plan participants, plan sponsors and the Department of Labor should any of the underlying assumptions be wrong about managed accounts, target-date funds or balanced funds.
GINA MITCHELL
Stable Value Investment Association
Washington
