The Relative Performance of Fundamental Indexing over the Cycle | BetaShares

The Relative Performance of Fundamental Indexing over the Cycle

BY David Bassanese | 16 February 2016
Due to the tendency of stock prices to over and undershoot fundamentals over the economic cycle, both finance theory and empirical evidence suggests that “fundamentally weighted” equity indices (FWIs) should over time outperform more traditional market-cap weighted equity indices (MCWIs).  We have previously explored the relative performance of FWIs in relation to sector rotation over time.  This note explores in more detail the relative performance of the fundamentally weighted FTSE RAFI Australia 200 Index (the index which our QOZ ETF aims to track) against that of the market-cap weighted S&P/ASX 200 Index over past market cycles. It shows that while the RAFI Index has had periods of both out performance and under performance over time, it’s long term relative performance has been positive.

The Theory: Why FWIs might outperform MCWIs over time

As previously explained, MCWIs weight stocks according to their price-based market capitalisation.  By contrast, a FWI weights stocks according to non-price related measures of their economic importance. In the case of the FTSE RAFI Australia 200 Index, for example, weights are based on four equally weighted factors: a company’s cash flow, dividends, sales and book value, with the first three of these measures averaged over the previous 5 years, and the last based upon the most recent accounting value.

As seen in the chart below, the upshot of this approach is that FWI’s will tend to be underweight stocks (compared to a MCWI) when their prices are relatively high compared to sales, earnings, book value and dividends, and overweight these stocks when their prices are relatively low compared to these other non-price measures of a company’s importance.  In what’s known as “regression to the mean” in value, to the extent relatively high price stocks eventually tend to under perform, and relatively low priced stocks eventually tend to outperform, finance theory suggests the FTSE RAFI Australian 200 Index should tend to outperform the S&P/ASX 200 over time.

Of course, this theory does not suggest FWIs will necessarily always outperform MCWIs.  Indeed, over any given market cycle – typically in the late stages of a bull market – it is not uncommon for already expensive stocks to continue to outperform (and so move further from “fair-value”) due to speculative euphoria (point B in the chart below). Similarly, as typically seen in the late stages of a bear market, it is not uncommon for already cheap stocks to continue to underperform as investors become overly pessimistic (point A in the chart below).
By contrast, at least conceptually, FWIs then tend to outperform when beaten down cheap stocks rally relatively strongly in the early stage of a bull market (point C in the chart above), and again when expensive stocks fall hardest in the early stage of a bear market (point D in the chart above).
So much for the theory. Whether FWIs outperform MSWIs over time is ultimately an empirical question.

The Evidence: FWIs have outperformed, albeit in “cycles”

As seen in the chart below, the FTSE RAFI Australia 200 Index has tended to outperform the S&P/ASX 200 index over time, though relative performance has nonetheless varied over shorter time periods.  Through most of the early 1990s, for example, the RAFI Index outperformed, culminating in a strong surge of outperformance 1998-99.   The most abrupt period of underperformance was during the height of the dotcom bubble between mid-1998 and early 2000. But the Index then again out performed as tech stocks crashed.
Relative Performance: S&P/ASX 200 Index v FTSE RAFI Australia 200 Index: May 1992-December 2015

Graph and table show performance of FTSE RAFI Australia 200 index relative to S&P/ASX 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 results.

More recently, the RAFI Index has underperformed again, with a return of only 0.4% in 2015 compared to 2.6% for the S&P/ASX 200 Index.  In this case RAFI underperformed largely due to two factors: an overweight sector exposure to the under performing resources sector, and an underweight to the strongly performing health care sector.  That said, in view of these cycles in relative performance, perhaps the most important statistic to note is this: since the early 1990s, the since inception outperformance of the RAFI Index over the S&P/ASX 200 Index has been 2.1% p.a.

As seen in the chart below, moreover, barring the sharp but temporary period of underperformance during the tech bubble (where market value dramatically exceed “fair value”), the RAFI Index performance has rarely lagged that of the S&P/ASX 200 Index by more than a couple of percentage points.
All up, although the RAFI Australia 200 Index has recently underperformed the S&P/ASX 200 Index, both finance theory and empirical evidence supports the view that the fundamental indexation strategy has the potential to add value to an investor’s portfolio. 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).


  1. Stephen  |  February 17, 2016

    That relative performance graph is a bit of a nightmare to understand. Firstly you don’t properly identify the relevant axis and then what does ‘relative performance’ really mean? If I take the right axis at a start of 100, does that mean by the end of the period the index cumulatively outperformed by 60%?

    I think a straight up comparison would have been easier to understand rather than mixing scales.

    1. David Bassanese  |  February 17, 2016

      Hi Stephen
      Thanks for your constructive feedback. I have amended the chart to separate out the relative performance index to make it a bit clearer. You are right in saying cumulative out performance has been 60%.

Leave a Reply