Research Affiliates Fundamental Index RAFI : Efficient Indexing for an Inefficient Market Dave Hennessy / hennessy@rallc.com
Research Affiliates, LLC Mission Concentrate on Research and product development Partner with world-class Affiliates to bring product to market Profile $30 billion in assets linked to RA-developed products Founded in 2002 by Rob Arnott Majority employee-owned Global leader in Global tactical asset allocation (GTAA) Innovative indexation Note: please refer to the disclosure slide at the end for all relevant disclaimers, disclosures, and information on our intellectual property. 2
Indexing: A Great Strategy for Equity Investment
Introduction Index funds are a compelling choice for investors Access to market returns at low cost Favorable portfolio attributes Superior performance over time relative to all active managers The cap-weighted approach leads to a performance drag Overweights the overpriced shares Underweights the underpriced shares The Fundamental Index approach eliminates this drag Weights stocks by non-price measures of firm size Achieves long-term excess returns of 2 4% in developed markets; greater in less efficient spaces Preserves many of the advantages of index fund investing 4
The Advantages of Passive Investing Cost Matters Hypothesis Market is cap-weighted so, collectively, active managers own the market less their higher costs Most active managers will underperform Index funds access market returns at low cost Favorable portfolio attributes Large investment capacity Low fees and expenses Diversification Broad market exposures Theoretical support Efficient Markets Hypothesis stock prices reflect all information; stock-picking is futile CAPM cap-weighted portfolio is optimal 5
Index vs. Active Management 10 Years 15 Years Domestic S&P 500 Index 8.2% 10.9% Average Equity Fund* 7.8% 10.2% Index Advantage 0.4% 0.7% International MSCI World ex US 8.0% 9.6% Average International Equity Fund** 7.2% 9.3% Index Advantage 0.8% 0.3% Note: And these are the survivors! *Consists of Morningstar Large Blend category. **Consists of Morningstar Foreign Large Blend category. Source: Morningstar, time periods ending March 31, 2007 (U.S.) and May 31, 2007 (Global). 6
Problem with Cap-Weighting: Mispricing If mispricing occurs, cap-weighting has a structural flaw Portfolio weights are inextricably linked to any pricing errors Overvalued stocks are overweighted Undervalued stocks are underweighted Portfolios are particularly vulnerable to pricing bubbles and subsequent corrections Mispricing is an empirical reality Mispricing is evident in most markets Massive bubbles: South Sea, Dutch Tulip, Nifty-Fifty Smaller bubbles: Krispy Kreme Donuts, Crocs, Ethanol Recent bubbles: Technology and.com 7
The Rise and Fall of Tech Stocks Growth of $1 $45 $40 $35 $30 $25 $20 $15 $10 $5 $0 PE Ratios (3/31/2000) Cisco 182 Nortel 122 Nokia 75 Ericsson 91 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Cisco Nokia Nortel Ericsson Source: Research Affiliates, based on data from Bloomberg. 8
RAFI Efficient Indexing for an Inefficient Market
The RAFI Approach Create an index that reflects a company s economic footprint using fundamental measures of size Sales Cash flow Gross dividends paid Book value The result, for any of these: Breaks the link between pricing errors and portfolio weights Pricing errors are uncorrelated (and cancel) For example, both overvalued and undervalued stocks will be overweighted and underweighted, but the errors largely offset each other Retains many benefits of an equivalent cap-weighted index Diversification, indeed, more than cap-weighted in bubbles Liquidity, transparency, and broad economic representation 10
Five Large Companies Based on Fundamentals (January 31, 2008) 5-Year Average Sales 5-Year Average Cash Flow $ Billion Weight Rank $ Billion Weight Rank Exxon Mobil Corp $ 264 3.0% 2 $ 46 3.0% 1 General Electric Co $ 141 1.6% 6 $ 29 1.9% 3 Citigroup Inc $ 111 1.3% 8 $ 37 2.5% 2 Bank of America Corp $ 72 0.8% 16 $ 27 1.8% 4 Wal-Mart Stores Inc $ 286 3.2% 1 $ 20 1.3% 8 Top 1000 Total $ 8,826 $ 1,510 5-Year Average Dividend Book Value $ Billion Weight Rank $ Billion Weight Rank Exxon Mobil Corp $ 7 3.3% 4 $ 114 2.0% 5 General Electric Co $ 9 4.2% 2 $ 112 2.0% 6 Citigroup Inc $ 7 3.5% 3 $ 119 2.1% 2 Bank of America Corp $ 6 3.0% 5 $ 132 2.3% 1 Wal-Mart Stores Inc $ 2 1.0% 19 $ 62 1.1% 14 Top 1,000 Total $ 210 $ 5,652 Source: Research Affiliates, based on data from Bloomberg. 11
RAFI Outperforms with Lower Volatility 1962-2007 Ending Value of $1 Annual Return Volatility Sharpe Ratio Tracking Error S&P 500 $90 10.3% 14.6% 0.37 1.7% Cap 1000 $88 10.2% 14.8% 0.36 -- Book $176 11.9% 14.6% 0.47 3.5% Cash Flow $214 12.4% 14.6% 0.50 3.8% Sales $248 12.7% 15.4% 0.50 4.8% Gross Dividend $174 11.9% 13.3% 0.50 5.1% RAFI Composite $207 12.3% 14.4% 0.50 4.0% The Cap 1000 is an annually rebalanced portfolio of the top 1,000 U.S. stocks by capitalization dating back to 1962. Results are based on RA research. Hypothetical or simulated performance results have certain inherent limitations. Unlike actual performance records, simulated results do not represent actual trading. Source: Research Affiliates, based on data from Bloomberg. 12
Benefits of a Composite Approach Any single-metric index works, but has a structural bias: Sales overexposed to large companies with thin margins Cash flow overexposed to cyclical stocks at cyclical peaks Dividends overexposed to mature, high-yield companies and exclusion of growth companies Book value overexposed to companies with aggressive accounting Composite approach improves methodology Diversifies exposure to data source, sectors, and other risks Improves robustness of methodology Improves stability of factors Superior risk return performance* *Research Affiliates historical data based on universe of U.S. equities 1962-2007. 13
2% Per Annum Adds Up Over Time, 1962 2007 $250 $200 $150 Return Volatility Value Add Beta Correlation RAFI U.S. Large 12.3% 14.4% 2.1% 0.93 0.96 Cap 1000 10.2% 14.8% $100 $50 $0 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 RAFI U.S. Large Cap 1000 Hypothetical or simulated performance results have certain inherent limitations. Unlike actual performance records, simulated results do not represent actual trading. Source: Research Affiliates, LLC. 14
RAFI Performance Over Market Cycles, 1962 2007 25% 20% 20.3% 19.6% Annual Return 13.4% 15% 11.6% 10% 6.4% 5% 3.0% 0% -5% -10% -15% -20% -18.1% -25% -30% -23.9% Bull Markets Bear Markets Expansionary Phase Recessionary Phase RAFI U.S. Large S&P 500 Index Hypothetical or simulated performance results have certain inherent limitations. Unlike actual performance records, simulated results do not represent actual trading. Source: Research Affiliates, based on data from Bloomberg. 15
RAFI vs. Cap-Weight: Different Return Environments, 1962 2007 30% RAFI U.S. Large 5-year Annualized Return 25% 20% 15% 10% 5% 0% -5% Average Value Add -10% -10% -5% 0% 5% 10% 15% 20% 25% 30% Cap 1000 5-year Annualized Return Source: Research Affiliates, LLC. 16
RAFI Underperforms in Irrational Bubbles RAFI U.S. Large vs. S&P 500: Rolling 5-Year Return (1967 2007) 12% 6% 10% 4% 8% 2% 6% 0% 4% -2% 2% -4% -6% 0% -2% -8% -10% -4% -12% -6% Nifty 50 Biotech 1967 1967 1969 1969 1971 1971 1973 1973 1975 1975 1977 1977 1979 1979 1981 1981 1983 1983 1985 1985 1987 1987 1989 1989 1991 1991 1993 1993 1995 1995 1997 1997 1999 1999 2001 2001 2003 2003 2005 2005 2007 2007 Nifty 50 RAFI U.S. Large minus S&P 500 5-Year Rolling Year Year Biotech Technology Technology RAFI Outperforms S&P 500 S&P 500 Outperforms RAFI Hypothetical or simulated performance results have certain inherent limitations. Unlike actual performance records, simulated results do not represent actual trading. Source: Research Affiliates, based on data from Bloomberg. 17
Largest Holdings on 30 June 2007 RAFI U.S. Large Cap 1000 Source: Research Affiliates, LLC. 18 Company Weight Company Weight 1 Exxon Mobil Corp 2.8% Exxon Mobil Corp 3.1% 2 General Electric Co 2.7% General Electric Co 2.5% 3 Citigroup Inc 2.1% Microsoft Corp 1.8% 4 Microsoft Corp 1.7% Citigroup Inc 1.6% 5 Bank of America Corp 1.7% Bank of America Corp 1.4% 6 Wal-Mart Stores Inc 1.6% Wal-Mart Stores Inc 1.3% 7 Verizon Communications Inc 1.5% Altria Group Inc 1.3% 8 Chevron Corp 1.4% Proctor & Gamble Co 1.2% 9 Altria Group Inc 1.4% Pfizer Inc 1.2% 10 Pfizer Inc 1.3% Chevron Corp 1.2% 11 JPMorgan Chase & Co 1.3% American International Group 1.1% 12 General Motors Corp 1.2% Johnson & Johnson 1.1% 13 AT&T Inc 1.2% JPMorgan Chase & Co 1.1% 14 Berkshire Hathaway 1.1% Cisco Systems Inc 1.1% 15 Ford Motor Co 1.1% AT&T Inc 1.0% 16 American International Group 1.1% IBM 1.0% 17 Proctor & Gamble Co 1.0% Intel Corp 0.9% 18 Johnson & Johnson 0.9% Conoco Philips 0.8% 19 Conoco Philips 0.9% Coca-Cola Co 0.8% 20 IBM 0.8% Berkshire Hathaway Inc 0.8% Total in top twenty 28.8% 26.2%
19 RAFI Applications Sectors
Sector Weights: Which is the Passive Strategy? Cap Weighted Fundamental Index Portfolio Composition 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 Other Util Telcom Tech Manu Dur Energy Finance Health Chem Non-Dur Retail Where s the rebalancing? Chasing the winners? 2006 Portfolio Composition 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 Other Util Telcom Tech Manu Dur Energy Finance Health Chem Non-Dur Retail Systematic rebalancing Buy low, sell high 2006 Source: Research Affiliates, LLC. 20
RAFI Applications Span the Equity Markets
RAFI Concept Works Globally 23 Country Return Statistics through 2007 Country RAFI Return MSCI Return Value Added Risk Adjusted Alpha Tracking Error Info Ratio Alpha t -statistic Start Date Ireland 17.6% 9.6% 7.9% 8.6% 9.1% 0.87 4.50 1988 Austria 17.8% 12.5% 5.4% 6.4% 9.7% 0.55 3.44 1984 Norway 17.5% 13.3% 4.2% 4.3% 6.5% 0.64 3.23 1984 Portugal 13.2% 9.2% 4.0% 4.6% 8.3% 0.48 2.64 1989 France p g p g 16.9% 12.9% 3.9% 4.4% 7.1% 0.56 3.08 1984 United Kingdom y 15.0% 12.1% 3.0% 3.1% 4.4% 0.68 3.45 1984 Japan y 7.1% 4.3% 2.8% 2.8% 5.4% 0.52 2.58 1984 United States 14.4% 12.4% 2.0% 2.7% 4.7% 0.42 2.90 1984 Belgium 15.5% 14.0% 1.5% 2.3% 5.6% 0.26 2.17 1984 Finland 15.8% 14.7% 1.1% 5.1% 20.3% 0.06 1.59 1988 Netherlands 14.0% 12.8% 1.1% 1.5% 6.6% 0.17 1.09 1984 New Zealand 7.2% 6.8% 0.4% 0.4% 8.7% 0.05 0.20 1988 Switzerland 11.6% 12.0% -0.4% -0.2% 4.3% -0.09-0.24 1984 23-Country Average 17.0% 14.4% 2.6% 3.1% 2.9% 0.90 5.50 Source: Research Affiliates, LLC. 22
Cumulative Value Added through December 2007 300.0 260.0 220.0 180.0 140.0 100.0 60.0 20.0 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Australia Austria Belgium Canada Denmark Finland France Germany Greece Hong Kong Ireland Italy Japan Netherlands New Zealand Norway Portugal Singapore Spain Sweden Switzerland United Kingdom United States Average 23
Target Country Weightings: Which is the Passive Strategy? 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1985 1989 1993 US UK France Other Europe Japan Cap Weighted 1997 2001 2005 Canada Germany Italy Asia Pacific ex Japan 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1985 Fundamental Index Target Weight 1989 1993 US UK France Other Europe Japan 1997 2001 2005 Canada Germany Italy Asia Pacific ex Japan Source: Research Affiliates, LLC. 24 Cap weighting overweights the overvalued countries Fundamental Index portfolio bypasses country bubbles
RAFI vs. Reference Cap Rolling Five Year Returns, 23 Countries 40% RAFI Annualized 5-Year Return 35% 30% 25% 20% 15% 10% 5% 0% -5% -10% For Cap Return < 0%, RAFI adds value in 97% of all cases For Cap Return 0-10%, RAFI adds value in 85% of all cases For Cap Return 10-20%, RAFI adds value in 77% of all cases For Cap Return 20-30%, RAFI adds value in 65% of all cases -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% Cap-Weighted Annualized 5-Year Return For Cap Returns > 30%, RAFI adds value in 44% of all cases Other Developed G5 Global Average Linear (Global Average) Source: Research Affiliates, LLC. 25
RAFI in Less Efficient Markets What happens to the return drag of cap weighting in less efficient markets? Less efficient markets will see greater mispricing, both in magnitude of error and frequency U.S. Small Company International Small Emerging Markets The end result Excess return benefits in line with active management expectations Capacity, liquidity, and low turnover expected of index fund investing 26
International Region Performance through 2007 Start Date Return Volatility Value Add Percent 3-Year Wins RAFI U.S. Large 1962 12.3% 14.4% 2.0% 73.9% S&P 500 (46 years) 10.3% 14.6% RAFI Japan 1984 7.2% 19.1% 2.8% 90.1% MSCI Japan (24 Years) 4.3% 19.4% RAFI Europe 1984 17.8% 16.2% 3.0% 93.7% MSCI Europe (24 Years) 14.8% 16.1% RAFI Global ex US 1984 15.6% 15.7% 3.3% 88.5% MSCI EAFE (24 Years) 12.3% 16.7% RAFI US Small 1979 16.2% 18.6% 3.4% 99.7% Russell 2000 (29 Years) 12.8% 19.0% RAFI Global ex US Small 1999 17.1% 13.3% 4.2% 94.5% MSCI EAFE Small (9 Years) 12.9% 15.2% RAFI AP ex Japan 1988 17.2% 21.1% 4.5% 70.7% MSCI Pacific ex Japan (20 Years) 12.7% 19.3% RAFI EM 1994 19.4% 23.3% 10.7% 100.0% MSCI EM (14 Years) 8.7% 22.4% Source: Research Affiliates, LLC. 27
RAFI Italy $7 $6 $5 Return Volatility Value Add Beta Correl RAFI Italy 13.2% 20.8% 2.6% 0.96 0.97 FTSE All World Italy 10.6% 21.1% $4 $3 $2 $1 $0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 RAFI Italy FTSE All World Italy 28 Source: Research Affiliates, LLC
RAFI UK $5.0 $4.5 $4.0 $3.5 Return Volatility Value Add Beta Correl RAFI UK 10.7% 13.0% 2.5% 0.95 0.95 FTSE All World UK 8.2% 13.0% $3.0 $2.5 $2.0 $1.5 $1.0 $0.5 $0.0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 RAFI UK FTSE All World UK 29 Source: Research Affiliates, LLC
RAFI Pan-Europe $60 $50 $40 Return Volatility Value Add Beta Correl RAFI Pan-Europe 17.6% 16.2% 2.8% 0.98 0.98 FTSE Europe 14.8% 16.1% FTSE Europe Value 16.5% 16.4% 1.7% 1.00 0.98 $30 $20 $10 $0 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 RAFI Pan-Europe FTSE Europe FTSE Europe Value 30 Source: Research Affiliates, LLC
RAFI Sector Performance U.S. (1989-2007) Global (1995-2007) RAFI Sector Return S&P Sector Return Value Added RAFI Sector Return MSCI Sector Return Value Added Information Technology 13.3% 11.0% 2.3% 12.3% 10.3% 1.9% Health Care 14.6% 12.3% 2.3% 13.6% 12.2% 1.4% Financials 13.9% 11.7% 2.2% 12.9% 9.3% 3.6% Consumer Staples 13.9% 11.7% 2.2% 12.8% 11.3% 1.5% Utilities 11.7% 9.5% 2.1% 14.0% 11.7% 2.2% Industrials 12.8% 11.0% 1.8% 11.8% 8.6% 3.2% Energy 16.3% 14.8% 1.5% 17.5% 16.7% 0.8% Materials 10.8% 9.4% 1.5% 13.6% 10.9% 2.7% Telecommunications 7.1% 6.7% 0.4% 12.8% 7.8% 5.1% Consumer Discretionary 7.7% 8.5% -0.8% 9.6% 6.9% 2.7% RAFI strategy outperforms in 9 out of 10 U.S. economic sectors RAFI strategy outperforms in 10 out of 10 Global economic sectors Source: Research Affiliates, LLC. 31
Common Critiques: Hits & Misses
Is The Fundamental Index Idea Just Value? The RAFI concept will typically exhibit a value tilt... Example two stocks with identical measures of fundamental size Fundamental Weighting Cap Weighting Book Value Cash Flow Sales Dividends Paid RAFI Weight Expected Earnings Growth P/E Cap Weight Stock A 4 2 8 1 2% 20% 40 4% Stock B 4 2 8 1 2% 5% 10 1% Market 200 100 400 50 100% 10% 20 100% Stock A with twice the multiple gets twice the weight Stock B with half the multiple gets half the weight Relative to a cap-weighted market portfolio, a RAFI portfolio has a value tilt While a cap-weighted portfolio is inherently neutral Relative to the current economy, cap weighting has a growth tilt While a RAFI portfolio is studiously neutral 33
RAFI Excess Returns Not Solely Value $70 $60 $50 RAFI U.S. Large vs. S&P 500 and Russell 1000 Value (1979 2007) Return Volatility Value Add Beta Correlation RAFI U.S. Large 15.4% 14.1% 2.3% 0.92 0.96 S&P 500 13.1% 14.7% Russell 1000 Value 14.1% 13.8% 1.0% 0.88 0.94 Growth of $1 $40 $30 $20 $10 $0 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 Hypothetical or simulated performance results have certain inherent limitations. Unlike actual performance records, simulated results do not represent actual trading. Source: Research Affiliates, based on data from Bloomberg. 34 RAFI U.S. Large S&P 500 Russell 1000 Value
RAFI Exposure to Value is Dynamic 75% 1.00 10-Year Growth vs. Value Relative Performance 50% 25% 0% -25% 0.75 0.50 0.25 0.00 RAFI Value Tilt -50% -0.25 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 10-Year Growth vs Value Relative Performance (Left Scale) RAFI Value Tilt vs Russell 1000 Value Index (Right Scale) Source: Research Affiliates, based on data from Bloomberg. 35
2007 Proof Statement 2007 Style and Size Excess Returns 2007 Fundamental Index Excess Returns over Cap-Weighted Benchmarks 10% 10% 9.2% 5% 5% 3.3% 5.5% 0% 0% 0.1% -2.3% -5% -5% -7.3% -10% -10.3% -9.8% -10% -12.0% -15% -15% -16.8% -20% U.S. Large (Russell 1000 Value minus Grow th) U.S. Small (Russell 2000 Value minus Grow th) International (MSCI EAFE Value minus Grow th) U.S. (Russell 2000 minus Russell 1000) International (MSCI EAFE Small minus EAFE) -20% RAFI U.S. Large minus S&P 500 RAFI U.S. Small minus Russell 2000 RAFI Int'l minus MSCI EAFE RAFI EM minus MSCI EM RAFI Int'l Small minus MSCI EAFE Small In a massive growth and large-cap year, 4 of 5 Fundamental Index portfolios outperformed 36
Using RAFI in Your Investment Strategy: Efficient Frontier, 1987 2007 Annualized Return 14% 12% 10% 8% 6% 4% Equivalent Return RAFI & Bond Lehman Aggregate 1-Month Treasury Return 60 RAFI 40 Bond Equivalent Risk RAFI & Bond 60% S&P 500 40% Bond RAFI U.S. Large S&P 500 2% 0% 0% 2% 4% 6% 8% 10% 12% 14% 16% Standard Deviation of Returns Source: Research Affiliates, LLC. 37
38 RAFI Works in Fixed Income
Cumulative Returns Cumulative Returns 250.00 240.00 230.00 220.00 210.00 200.00 190.00 180.00 170.00 160.00 150.00 140.00 130.00 120.00 110.00 100.00 90.00 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Merrill Lynch HY Master II Index Merrill Lynch Governm't 1-10 Sales Dividend Book Cash Flow Collateral Composite Equal Weight Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 39
36-Month RAFI HY Composite vs. ML High Yield Index 20.0% 16.0% 12.0% RAFI HY Composite 8.0% 4.0% 0.0% -4.0% -4.0% 0.0% 4.0% 8.0% 12.0% 16.0% 20.0% ML High Yield Index 40
Three-Year Returns for Emerging Markets Bonds RAFI vs. Cap-Weighted 30.0% 25.0% RAFI EMB Returns 20.0% 15.0% 10.0% 5.0% 5.0% 10.0% 15.0% 20.0% 25.0% Cap-Weighted EMB Returns 41
Cumulative Return: Emerging Market Bond Index 400 350 300 Growth of $100 250 200 150 100 50 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Equal Weighted Cap-Weighted Composite Population Area GDP Oil Expenditures GNI Debt 42
Efficient Indexing for an Inefficient Market Cap-weighting has a rich history, but has definite shortcomings The RAFI strategy addresses the shortcomings of cap weighting while maintaining the benefits of a broad market index Consistently outperforms its cap-weighted counterparts, especially in bear markets Adds more value as pricing errors increase (i.e., in less-efficient markets like emerging markets, international, and small-cap) Consistently beats the cap-weighted index and most actively managed funds 43
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