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Is a ‘revitalised’ Rafi Emerging index due a turnaround in performance?
by Robert St George on Oct 29, 2013 at 08:15
They should be the totems of smart beta strategies. Research Affiliates creates alternative equity indices that are not based on market capitalisation, but rather weight constituents according to four fundamental factors: dividends paid out; free cash flow; total sales; and book value.
This approach has worked well in developed markets. The FTSE Research Affiliates Fundamental index (Rafi) is derived from the 1,000 companies with the highest scores on those four criteria listed on the FTSE Developed All Cap index.
Over both one and five-year periods, this Rafi product has outperformed its parent by five percentage points. So far this year it is ahead too, with a return of 19.9% to the broader basket’s 17.4%.
Yet there is a disappointing member of the Rafi family. The FTSE Rafi Emerging index consists of the 350 stocks with the best fundamental ratings drawn from the FTSE Emerging All Cap index, which it has lagged in both rising and falling markets.
Since 2008, when the wider index has gained 42.5%, the FTSE Rafi Emerging index has risen by 40.9%. In the emerging market turmoil since January, Rafi has lost 1.8 percentage points more than its parent, with a 6.8% fall. Most worryingly, Rafi has dropped by 2.5% over the past 12 months, even as the FTSE Emerging All Cap index has climbed by 0.5%.
So what has gone wrong with this smart beta approach to emerging markets?
Quite simply, it has been a question of style. An index that emphasises market capitalisation is one that rewards price momentum. It is, in essence, a growth strategy. Shares are bought as they appreciate into the index and sold as they slip out of it.
This has advantages: it is liquid, low cost, and successful when the market is looking for growth.
In contrast, the Rafi index has a far greater value bias. Taking book value into account obviously bends Rafi in that direction – as, to a lesser extent, does the prominence given to dividends.
In practice, this has left Rafi with significant allocations to both the oil sector and Russia – calls that have been contrarian for a long time now. Russia represents 14% of the Rafi index, double that of the FTSE Emerging All Cap index. Similarly, 13% of the FTSE index is held in oil and gas companies, compared with a quarter of Rafi.
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