Fundamental Indexing Goes Main Street

For the U.S. FTSE/RAFI 1000 we choose the 1,000 largest companies–not by market cap–but by measures of the financial size of a company. What measures would people on Main Street think of as sensible measures of a company? Not market cap. People on Main Street would think: What are the company's sales? What are its profits? What's its book value? How much could it afford to pay out in dividends every year?

We look at a company's sales, profits, book value, and dividends. If a company is 4% of the economy by sales, 3% by book value and profits, and 2% by the dividends that it pays, then, we could argue is it 2% or 3% or 4% of the economy or we could just take the average, and say "It's about 3% of the economy and therefore it will be 3% of our index." We simply equal-weight the four measures; if a company has never paid a dividend we just weight the other three–we don't want to saddle a company with zero weight for dividends. It's a simple process and that's what makes it doubly amazing that it hadn't been explored decades ago.

The genesis for this was in early '02; the market was down 25% on its way to being down 47%, the average stock was up 20%! Most companies went up in 2000, 2001, most companies went up in the first quarter of 2002, so for two years after the bubble burst, for most companies it was a bull market. The bull market of the '90s didn't end until April of 2002–for most companies. How many people out there think of 2000 and 2001 as bull market years? They don't–because the indexes were all down, and for far too many people their portfolios were all down. Why? Because they were loaded up in these ultra-high-flying, ultra-high-multiple growth stocks that, in retrospect, were revalued.

So, what you're doing is kind of what a value manager would look at for an actively managed portfolio, but you're including a much larger universe in the portfolio?

We're including a larger universe, and staying away from subjective judgments about what a company is worth. We're also staying away from the value manager's temptation to say, "Google is too expensive and I won't own it." We look at it and we say, "Perfectly good company, here are its sales, its profits, here's its book value; doesn't pay dividends so we'll ignore that. Its footprint in the economy is, I don't know, .03%, so let's weight it .03%." We don't make the secondary judgment of, it's going to be worth .5% of the economy in five or 10 years and let's go ahead and pay for that now as if that's already happened–that's what cap-weighting does.

Then what happened?

We tested in all 10 of the S&P sectors going back 17 years, found it adds value in 10 out of 10, no exceptions. We've tested in some niche markets–small companies–our [RAFI] 2000 against the Russell 2000; [the RAFI] adds 3.5% per year, going back 27 years. In small company space it's not because of a small company tilt or value tilt. Why?

Think about the companies in the Russell 1000 and not the RAFI 1000: they'll be companies that are large cap, but small companies. Small companies that are large cap are trading at lofty enough multiples to take them into large-cap space. Those drop into our [RAFI] 2000 because they are small companies, so we have some ultra-high-flyer, ultra-high-multiple, growth stocks that are big cap companies that drop into our small company universe. That means we've got some big-cap names and some very-high-multiple names.

These stocks neutralize what would normally be a value tilt in the index. And they actually flip the small-cap bias to large-cap, because there are enough large-cap names that drop into this list. What it means is our small company list is larger cap and is not value-tilted, therefore according to standard metrics, which say small beats large and value beats growth, we should slightly underperform the Russell Index. We don't, we outperform by 3.5% a year, because the [Russell] Small-Cap Index is cap weighted; it overweights the overvalued and underweights the undervalued, and we don't. So that's the best evidence that I've got that it's not just a small-cap and value tilt that's creating the alpha.