A Question of Style: Why fundamentally weighted indices have the potential to outperform value over time

A number of value-oriented investment strategies have underperformed in recent years as successful “growth” sectors such as the technology and health care sectors have continued to be favoured by investors. That said, due to the tendency of markets to “regress to the mean”, history suggests that extended periods of outperformance by one style strategy are eventually followed by periods of underperformance – in other words, markets go through cycles of “style rotation”. Such style rotation, moreover, is a major reason why fundamental-indexing strategies have tended to outperform traditional value indexing approaches historically.

Growth vs. Value

Two key investing styles tend to dominate the performance of equity markets over time: value and growth. Value investing is focused on finding companies that appear relatively cheap on traditional value criteria such as price to earnings, book value or sales. Growth investing, by contrast, is focused on finding companies with high earnings growth potential.

Several organisations have created market indices to broadly capture the performance of these differing investment styles over time. In the United States, for example, FTSE Russell rank companies in their broad FTSE Russell 1000 Index according to their price to book value, sales and earnings growth. Companies with relatively low price-to-book value and low earnings/sales growth are then placed in the “Value Index”, whereas companies with relatively higher earnings/sales growth and high price-to-book values are placed in the “Growth Index”.

As seen in the chart below, the relative performance of growth vs. value stocks has varied over time. That said, there has been a relatively long period of value underperformance since around early 2007.

In Australia, MSCI has also split the Australian market into both value and growth sub-sectors using broadly similar ranking of each stock’s growth and value characteristics. As seen in the chart below – and in contrast to the United States – value has tended to outperform growth since mid-2008, though there was underperformance earlier last decade and since early 2015.

The FTSE RAFI Fundamentally Weighted Indices

As we have previously explained, the FTSE RAFI suite of fundamentally-weighted equity market indices (FWIs) weights stocks according to non-price measures of company size – such as sales, dividends, book value and cash flows. For example, assume the aggregate book value and total market capitalisation of the stocks within a hypothetical index were both equal to $100 billion (i.e. the average price to book value of stocks covered by this index equalled 1).

If we assume this hypothetical index was weighted by book value alone, if company X had a book value of $2 billion, yet market capitalisation of only $1 billion, its weight with a FWI based on book value alone would be 2%, or twice that of its 1% weight in a market capitalisation weighted index (given the index has an aggregate book value and total market capitalisation of $100 billion). The stock’s higher weight in a FWI reflects its relatively low price to book value compared to other stocks.

As should be evident, FWIs tend to have value characteristics – as they tend to weight more highly stocks with relatively low valuation measures. In the case of the United States, this is reflected in the fact that the relative performance of the FTSE RAFI U.S. 1000 Index is broadly correlated to that of the Russell 1000 Value Index. Both indices tended to outperform the broader market from mid-2000 to mid-2007, for example, and underperformed during the financial crisis of 2007-2008 and the tech boom of 1998-2000. Accordingly, it’s fair to say the general under performance of value stocks in recent years has been a headwind for the relative performance of the FTSE RAFI U.S. 1000 Index.

Graph shows performance of FTSE RAFI U.S. 1000 index, not ETF performance and does not take into account ETF management costs. You cannot invest directly in an index. Past performance is not an indicator of future performance of index or ETF.

That said, it is important to note that the FTSE RAFI U.S. 1000 Index has nonetheless historically exhibited an outperformance bias against the Russell 1000 Value Index. This was apparent both during and following the early 1990s tech boom and in the early stage of recovery from the financial crisis in 2009. Over recent years, moreover, the FTSE RAFI U.S. 1000 Index has broadly tracked the performance of the Russell 1000 Index even though the Russell 1000 Value Index has underperformed.

In the case of Australia, the FTSE RAFI Australia 200 Index has tended to display relatively better performance than the S&P/ASX 200 Index, even though the “value” sector of the Australian market has not tended to outperform. Indeed, against the MSCI Value Index, the FTSE RAFI Australia 200 Index displayed relatively strong outperformance during the commodity boom prior to the financial crisis and again since early 2015.

Graph shows performance of FTSE RAFI Australia 200 index, not ETF performance and do not take into account ETF management costs. You cannot invest directly in an index. Past performance is not an indicator of future performance of index or ETF. The FTSE RAFI Australia 200 Index was launched on 10/8/2009. Index returns prior to launch are simulated based on Research Affiliates’ patented non-capitalisation weighted indexing system, method and computer program product. Actual investment results may differ from simulated result.

The relative performance of the FTSE RAFI US and Australian Indices are detailed in the table below.

In the US, the FTSE RAFI U.S. 1000 Index outperformed the S&P 500 over the past 10 years, though slightly underperformed over shorter time periods – not helped by the fact that value stocks have generally underperformed. That said, the FTSE RAFI U.S. 1000 Index has outperformed the S&P 500 Value Index over all times periods indicated.

In the case of Australia, the FTSE RAFI Australia 200 Index has outperformed the S&P/ASX 200 Index over the past 5 and 10 years, though underperformed (slightly) on a 3 year basis, and more notably over the past year. But the FTSE RAFI Australia 200 Index has nonetheless outperformed the MSCI Value Index over most of the time periods indicated, and has done notably better than the dreadful performance of value stocks over the past year.

Table shows performance of FTSE RAFI Australia 200 index and FTSE RAFI U.S. 1000 Index, not ETF performance and does not take into account ETF management costs. You cannot invest directly in an index. Past performance is not an indicator of future performance of index or ETF. The FTSE RAFI Australia 200 Index was launched on 10/8/2009. Index returns prior to launch are simulated based on Research Affiliates’ patented non-capitalisation weighted indexing system, method and computer program product. Actual investment results may differ from simulated result.

Conclusion: Why Have the Fundamentally Weighted Indices Historically Outperformed Value Indices?

Of course, all this begs the question: why has the FTSE RAFI Fundamental Weighting Methodology historically tended to consistently outperform standard value market indices (SVIs) over time? The essential reason is that SVIs tend to rank all stocks by value and then allocate the top ranking value stocks to the value index, but weight them in this index by market capitalisation.

The result? Those stocks that tend to perform best and experience rising valuations (i.e. a rise in price relative to earnings, sales or book value) tend to gain a higher weight in SVIs relative to FWIs over time. Indeed, the more “value” stocks as a group tend to outperform the market (i.e. due to rising market value), the less weight they are given in FWIs relative to “growth” stocks. In fact FWI’s weightings tend toward that of the overall style-neutral market-cap index when value stocks enjoy a strong run over an extended period.

When regression to the mean strikes – and overvalued “value” stocks eventually underperform growth stocks – the higher weight of value stocks in SVIs relative to FWIs tends to cause the former indices to underperform the latter.

In a sense, the FTSE RAFI Fundamental Weighting Methodology involves placing a contrarian bet on value stocks as and when value stocks tend to experience a strong bull run.

BetaShares FTSE RAFI Australia 200 and FTSE RAFI U.S. 1000 ETFs

BetaShares currently has two ETFs which track indices based on the RAFI fundamental indexation methodology – the BetaShares FTSE RAFI Australia 200 ETF (ASX: QOZ) and the BetaShares FTSE RAFI U.S. 1000 ETF (ASX: QUS). As seen in the charts below, the underlying indices associated with these funds have both demonstrated relatively good performance over the long-term against the S&P/ASX 200 and US S&P 500 Indices respectively.

Graph shows performance of FTSE RAFI Australia 200 index and FTSE U.S. 1000 Index, not ETF performance and do not take into account ETF management costs. You cannot invest directly in an index. Past performance is not an indicator of future performance of index or ETF. The FTSE RAFI Australia 200 Index was launched on 10/8/2009. Index returns prior to launch are simulated based on Research Affiliates’ patented non-capitalisation weighted indexing system, method and computer program product. Actual investment results may differ from simulated result.

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