Eliminating the Price Effect of an Index Automatically Changes the Basic Characteristics of the Index

Decent Essays
By the attempt to eliminate the price effect from an index fund, the fundamental index managers change the set-up of the index in such a way that it automatically changes the basic characteristics of the index. As shown in exhibit 10 of the Research Affiliate case, fundamental indices usually not only deal with a higher turnover ratio but also with a higher net expense ratio, for implementing the fundamental strategy in reality seems to go hand in hand with higher costs.
Looking at commonly used multiples in exhibit 11, we see no surprises. While the P/E ratio for the RAFI index is only slightly smaller compared to the Russell 1000 index, the Price to Book/Cash Flow/Sales ratio is fundamentally lower in all categories for the RAFI index. More interesting is the fact that the RAFI index is composed of companies with an on average lower market capitalization as well as a higher leverage ratio, which might be a hint that the RAFI is also taking on more risk to produce the excess returns. Even though Research Affiliates uses several methods to eliminate a bias towards a specific sector/type of company, research shows that fundamental indices are clearly more exposed to value and small stocks, which is further illustrated in exhibits 12 & 14.
Looking at exhibits 11 & 13 we directly observe RAFI’s strong exposure towards financial institutions. Citigroup and Bank of America alone account for roughly 15% of the index while Citigroup is not even found within the 10 largest
Get Access