The RAFI® approach is based on the premise that traditional indexes are flawed in the way they handle mispricing.
During the years leading up to the global financial crisis, financial companies like Wells Fargo and American Express traded on average at about 2.2x book value.
As the market bottomed in March 2009, financials traded at less than 0.5x book value before climbing back to pre-2009 levels.
The bursting of these bubbles offers evidence of the existence of mispricing. An index strategy that weights by non-price measures would have rebalanced into these financial stocks when their prices were low and their valuations were attractive.
Financial bubble visualized
Source: Research Affiliates®, LLC and Factset, Dec. 31, 2010
In an effort to mitigate the effects of mispricing, the Fundamental Index methodology assigns weights to stocks based on four fundamental factors:
- Book value
- Trailing five-year average cash flow
- Trailing five-year average sales
- Trailing five-year average gross dividends
These are objective factors that exist independently of a stock's price and seek to provide metrics of size that are not swayed by the whims of the market.