Does Fundamental Indexation Really Offer Unique Superior Risk-Return Characteristics?
8 Pages Posted: 6 Feb 2017
Date Written: February 5, 2017
Over the last decade, the concept of ‘smart beta’ has emerged as one of the most disruptive trends in the financial industry. The pioneering paper ‘Fundamental Indexation’ by Arnott, Hsu and Moore (2005) stimulated an extensive discussion about the benefits and drawbacks of factor-based investment products, but there has been limited scrutiny of how the indices perform – that is, whether they are successful in their core focus. Using annual data for the oldest ‘smart beta’ exchange-traded fund, PowerShares FTSE RAFI US 1000 (RAFI), we compute several widely-accepted measures of risk and analyse the performance of this fund in different time frames. We compare this fund with the two main cap-weighted indices – the S&P 500 and the Russell 1000 – or, more precisely, with their exchange-traded versions – the SPDR S&P 500 ETF Trust and the iShares Russell 1000 ETF.
We find that the RAFI outperforms the index-based ETFs by 0.9% and 1.0% respectively in compound annual growth rate terms (2006-2016), but we believe that this is overwhelmingly due to the performance of the index in 2009, when the RAFI outperformed the S&P 500 by 16.0% and the Russell 1000 by 14.2%. Without this anomaly (i.e. if RAFI earned the same return as Russell 1000 in 2009), the index’s returns are reduced to only outperform S&P 500 and Russell 1000 by 0.17% and 0.04% respectively. We provide evidence that the source of the out-performance in 2009 is not likely to arise from the core nature of the index. We feel that there are two possible reasons for it, the rebalancing of the RAFI and the timing of this rebalancing. These findings then accentuate several risks that we believe the ‘smart beta’ strategies to carry, and show that investors should increase their scrutiny of the sector.
Keywords: 'Smart beta', stock market, fundamental indexation, factor investing, exchange-traded fund
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