Does the RAFI strategy have a bias toward value and smaller cap stocks?
RAFI strategies weight companies by their economic footprint. Accordingly, it is neutral relative to the composition and weightings of business enterprises in the economy. Cap-weighting, in contrast, has a stark growth tilt—companies at twice the market multiple get double their economic weight, while companies at half the market multiple get half their economic weight.
RAFI strategies have a value tilt but very little small-cap tilt. These tilts, however, are dynamic: when value stocks are out of favor and thus are cheap, Fundamental Index strategies tend to increase their allocation to deep value stocks; this phenomenon was vividly displayed in March 2009 when financial, industrial and consumer discretionary stocks when priced at bargain-basement levels. When value is in favor, the value tilt is much milder because these stocks tend to be priced higher. Rebalancing into unloved stocks and out of the most popular stocks—which we call “contra trading”–provides the majority of RAFI strategies’ added value.
Related Questions
- If academic research demonstrates that small cap/value stocks have higher returns than large cap/growth stocks over time, why not put 100% of the equity allocation into small cap and value stocks?
- With a defensive stock strategy, are value stocks a better play than growth stocks?
- Large vs. small cap stocks - where is the value?
