1
The Fundamental Indexing Conundrum
Gaetan “Guy” Lion
April 2010
2
Introduction on Fundamental Indexing
• Robert D. Arnott develops fundamental indexes that weigh companies based on: 1) Sales (avg. over 5 years), 2) Cash flow (avg. over 5 years), 3) Book value (most recent), and 4) Dividends (avg. over 5 years).
• He starts an investment firm, Research
Affiliates that launches with PowerShares several ETFs using his indexing methodology.
• The basic rational is to reduce exposure to bubbling stocks that are overweighed within a market cap index.
3
Thoughts…
• Fundamental indexes, being defensive, to fare better than market cap ones during Bear markets.
• Market cap indexes to fare better in Bull markets because they capture upward momentum.
• Over long cycles both approaches to generate similar returns.
4
Back testing
Robert Arnott back-tests his (RAFI) indexes over decades. And, discloses his results (shown below) within his book:
Large U.S. EquitiesAnnual returns over the 1962 to 2007 period
Bull BearOverall Markets Markets
RAFI U.S. Large 12.30% 20.30% -18.10%S&P 500 10.30% 19.60% -23.90%Advantage 2.00% 0.70% 5.80%
Small U.S. EquitiesAnnual returns over the 1979 to 2007 period
Bull BearOverall Markets Markets
RAFI U.S. Small 16.40% 33.10% -26.70%Russell 2000 12.90% 30.80% -31.90%Advantage 3.50% 2.30% 5.20%All RAFI index returns earned with nearly exact samelevel of volatility as traditional market cap indexes.
5
The Debate
• Some say it is just Value investing.• Others state this approach is flawed. A
company with rising earnings of $5, $10, and $15 over past 3 years would have same weighing as one experiencing declining earnings of $15, $10, and $5.
• Proponents state it avoids market inefficiencies with specific sectors bubbling.
6
Empirical investigation
• Arnott launched his main fundamental index funds PowerShares FTSE RAFI US 1000 (large cap) and PowerShares FTSE RAFI US 1500 (small & mid cap) just a year before the 2007 Crash.
• This recent Bear market is a good test for the fundamental index approach.
• We will review the performance of both funds during the recent Crash and Recovery phases of the stock market.
7
Large Cap indexes correlation
The large cap fundamental index (PRF) is slightly more correlated with value oriented indexes. We will compare PRF’s performance to the other indexes.
Name of index fund or index Acronym Correl.PowerShares FTSE RAFI US 1000 PRFS&P 500 ^GSPC 0.972Russell 1000 Index ^RUI 0.930Russell 1000 Index - Value ^RLV 0.978Vanguard Value Index (Large cap.) VIVAX 0.977
8
PRF vs S&P 500 in the recent Crash
30
40
50
60
70
80
90
100
110
7/13/07
8/13/07
9/13/07
10/13/07
11/13/07
12/13/07
1/13/08
2/13/08
3/13/08
4/13/08
5/13/08
6/13/08
7/13/08
8/13/08
9/13/08
10/13/08
11/13/08
12/13/08
1/13/09
2/13/09
PRF
S&P 500
The Crash (7/13/07 = 100): PRF vs S&P 500
9
PRF vs S&P 500 in the current Recovery
The Recovery (3/09/09 = 100): PRF vs S&P 500
80
100
120
140
160
180
200
220
3/9/09
4/9/09
5/9/09
6/9/09
7/9/09
8/9/09
9/9/09
10/9/09
11/9/09
12/9/09
1/9/10
2/9/10
3/9/10
PRF
S&P 500
10
PRF vs S&P 500 since onsetSince onset (12/20/05 = 100). PRF vs S&P 500
40
50
60
70
80
90
100
110
120
130
140
12/2
0/05
3/20
/06
6/20
/06
9/20
/06
12/2
0/06
3/20
/07
6/20
/07
9/20
/07
12/2
0/07
3/20
/08
6/20
/08
9/20
/08
12/2
0/08
3/20
/09
6/20
/09
9/20
/09
12/2
0/09
PRF
S&P 500
% Difference: (PRF - S&P 500)/PRF
-10%
-5%
0%
5%
10%
15%
20%
12
/20
/05
3/2
0/0
6
6/2
0/0
6
9/2
0/0
6
12
/20
/06
3/2
0/0
7
6/2
0/0
7
9/2
0/0
7
12
/20
/07
3/2
0/0
8
6/2
0/0
8
9/2
0/0
8
12
/20
/08
3/2
0/0
9
6/2
0/0
9
9/2
0/0
9
12
/20
/09
11
PRF vs Russell 1000 (RUI)
30
40
50
60
70
80
90
100
110
7/13/2007
8/13/2007
9/13/2007
10/13/2007
11/13/2007
12/13/2007
1/13/2008
2/13/2008
3/13/2008
4/13/2008
5/13/2008
6/13/2008
7/13/2008
8/13/2008
9/13/2008
10/13/2008
11/13/2008
12/13/2008
1/13/2009
2/13/2009
PRF
RUI
The Crash (7/13/07 = 100): PRF vs RUI The Recovery (3/09/09 = 100): PRF vs RUI
80
100
120
140
160
180
200
220
3/9/2009
4/9/2009
5/9/2009
6/9/2009
7/9/2009
8/9/2009
9/9/2009
10/9/2009
11/9/2009
12/9/2009
1/9/2010
2/9/2010
3/9/2010
PRF
RUI
Since onset (12/20/05 = 100). PRF vs RUI
40
50
60
70
80
90
100
110
120
130
140
12/2
0/20
05
3/20
/200
6
6/20
/200
6
9/20
/200
6
12/2
0/20
06
3/20
/200
7
6/20
/200
7
9/20
/200
7
12/2
0/20
07
3/20
/200
8
6/20
/200
8
9/20
/200
8
12/2
0/20
08
3/20
/200
9
6/20
/200
9
9/20
/200
9
12/2
0/20
09
PRF
RUI
% Difference: (PRF - RUI)/PRF
-10%
-5%
0%
5%
10%
15%
20%
12/
20/2
005
3/2
0/20
06
6/2
0/20
06
9/2
0/20
06
12/
20/2
006
3/2
0/20
07
6/2
0/20
07
9/2
0/20
07
12/
20/2
007
3/2
0/20
08
6/2
0/20
08
9/2
0/20
08
12/
20/2
008
3/2
0/20
09
6/2
0/20
09
9/2
0/20
09
12/
20/2
009
12
PRF vs Russell 1000 Value
30
40
50
60
70
80
90
100
110
7/13/2007
8/13/2007
9/13/2007
10/13/2007
11/13/2007
12/13/2007
1/13/2008
2/13/2008
3/13/2008
4/13/2008
5/13/2008
6/13/2008
7/13/2008
8/13/2008
9/13/2008
10/13/2008
11/13/2008
12/13/2008
1/13/2009
2/13/2009
PRF
RLV
The Crash (7/13/07 = 100): PRF vs RLV The Recovery (3/09/09 = 100): PRF vs RLV
80
100
120
140
160
180
200
220
3/9/2009
4/9/2009
5/9/2009
6/9/2009
7/9/2009
8/9/2009
9/9/2009
10/9/2009
11/9/2009
12/9/2009
1/9/2010
2/9/2010
3/9/2010
PRF
RLV
Since onset (12/20/05 = 100). PRF vs RLV
40
50
60
70
80
90
100
110
120
130
140
12/2
0/20
05
3/20
/200
6
6/20
/200
6
9/20
/200
6
12/2
0/20
06
3/20
/200
7
6/20
/200
7
9/20
/200
7
12/2
0/20
07
3/20
/200
8
6/20
/200
8
9/20
/200
8
12/2
0/20
08
3/20
/200
9
6/20
/200
9
9/20
/200
9
12/2
0/20
09
PRF
RLV
% Difference: (PRF - RLV)/PRF
-5%
0%
5%
10%
15%
20%
25%
12/
20/2
005
3/2
0/2
006
6/2
0/2
006
9/2
0/2
006
12/
20/2
006
3/2
0/2
007
6/2
0/2
007
9/2
0/2
007
12/
20/2
007
3/2
0/2
008
6/2
0/2
008
9/2
0/2
008
12/
20/2
008
3/2
0/2
009
6/2
0/2
009
9/2
0/2
009
12/
20/2
009
13
PRF vs Vanguard Value (VIVAX)
30
40
50
60
70
80
90
100
110
7/13/2007
8/13/2007
9/13/2007
10/13/2007
11/13/2007
12/13/2007
1/13/2008
2/13/2008
3/13/2008
4/13/2008
5/13/2008
6/13/2008
7/13/2008
8/13/2008
9/13/2008
10/13/2008
11/13/2008
12/13/2008
1/13/2009
2/13/2009
PRF
VIVAX
The Crash (7/13/07 = 100): PRF vs VIVAX The Recovery (3/09/09 = 100): PRF vs VIVAX
80
100
120
140
160
180
200
220
3/9/2009
4/9/2009
5/9/2009
6/9/2009
7/9/2009
8/9/2009
9/9/2009
10/9/2009
11/9/2009
12/9/2009
1/9/2010
2/9/2010
3/9/2010
PRF
VIVAX
Since onset (12/20/05 = 100). PRF vs VIVAX
40
50
60
70
80
90
100
110
120
130
140
12/2
0/20
05
3/20
/200
6
6/20
/200
6
9/20
/200
6
12/2
0/20
06
3/20
/200
7
6/20
/200
7
9/20
/200
7
12/2
0/20
07
3/20
/200
8
6/20
/200
8
9/20
/200
8
12/2
0/20
08
3/20
/200
9
6/20
/200
9
9/20
/200
9
12/2
0/20
09
PRF
VIVAX
% Difference: (PRF - VIVAX)/PRF
-15%
-10%
-5%
0%
5%
10%
15%
12/
20/2
005
3/2
0/2
006
6/2
0/2
006
9/2
0/2
006
12/
20/2
006
3/2
0/2
007
6/2
0/2
007
9/2
0/2
007
12/
20/2
007
3/2
0/2
008
6/2
0/2
008
9/2
0/2
008
12/
20/2
008
3/2
0/2
009
6/2
0/2
009
9/2
0/2
009
12/
20/2
009
14
Table Summary for Large Cap
The fundamental index fund (PRF) beat out handsomely the other benchmarks over the entire period by 2.3 to 5.1 percentage points in annual return. But, it did it by fairing poorly in the 2007 Crash and extraordinarily well in the 2009 Recovery.
Level of risk (daily volatility) is similar.
Name of index fund or index Acronym Crash Recovery Since onsetPowerShares FTSE RAFI US 1000 PRF -43.5% 110.8% 1.4%S&P 500 Index ^GSPC -39.4% 69.1% -2.2%Russell 1000 Index ^RUI -39.5% 71.4% -1.9%Russell 1000 Index - Value ^RLV -44.3% 75.8% -3.7%Vanguard Value Index (Large cap.) VIVAX -41.9% 77.6% -0.8%
Pow. FTSE RAFI US 1000 advantage Crash Recovery Since onsetS&P 500 Index ^GSPC -4.0% 41.7% 3.7%Russell 1000 Index ^RUI -4.0% 39.3% 3.3%Russell 1000 Index - Value ^RLV 0.9% 34.9% 5.1%Vanguard Value Index (Large cap.) VIVAX -1.6% 33.1% 2.3%
Volatility of daily returns over entire period (since 12/20/2005).PowerShares FTSE RAFI US 1000 PRF 1.76%S&P 500 Index ^GSPC 1.64%Russell 1000 Index RUI 1.72%Russell 1000 Index - Value ^RLV 1.79%Vanguard Value Index (Large cap.) VIVAX 1.77%
Annualized return
Annualized return difference
15
Large Cap: Back Testing vs Actual
The relative performance of the RAFI large cap was very different during the two periods. While in the 45 years of back testing, it excelled at besting the S&P 500 in Bear markets while recording only a small advantage in Bull markets; in the actual 4.25 years it faired poorly in the Crash of 2007. But, did extremely well in the Recovery of 2009.
Large U.S. Equities.
Back testing 1962 to 2007 periodBull Bear
Overall Markets MarketsRAFI U.S. Large 12.30% 20.30% -18.10%S&P 500 10.30% 19.60% -23.90%Advantage 2.00% 0.70% 5.80%
Actual annualized results 12/20/2005 - 3/10/2010Bull Bear
Overall Market MarketRAFI U.S. Large 1.43% 110.75% -43.46%S&P 500 -2.22% 69.09% -39.42%Advantage 3.65% 41.66% -4.05%
16
Small Cap indexes correlation
Fundamental index (PRFZ) correlation to value index or regular ones are equally high.
Name of index fund or index Acronym Correl.PowerShares FTSE RAFI US 1500 Small-Mid PRFZiShares Russell 2000 Index IWM 0.96Vanguard Small Cap Value Index VISVX 0.97Vanguard Mid-Cap Value Index VMVIX 0.95
17
PRFZ vs Russell 2000 (IWM)
30
40
50
60
70
80
90
100
110
7/13/07
8/13/07
9/13/07
10/13/07
11/13/07
12/13/07
1/13/08
2/13/08
3/13/08
4/13/08
5/13/08
6/13/08
7/13/08
8/13/08
9/13/08
10/13/08
11/13/08
12/13/08
1/13/09
2/13/09
PRFZ
IWM
The Crash (7/13/07 = 100): PRFZ vs IWM VISVX (7/13/2007): PRFZ vs
The Recovery (3/09/09 = 100): PRFZ vs IWM
80
100
120
140
160
180
200
220
240
260
3/9/09
4/9/09
5/9/09
6/9/09
7/9/09
8/9/09
9/9/09
10/9/09
11/9/09
12/9/09
1/9/10
2/9/10
3/9/10
PRFZ
IWM
Since onset (9/20/06 = 100). PRFZ vs IWM
40
50
60
70
80
90
100
110
120
130
140
9/20
/06
11/2
0/06
1/20
/07
3/20
/07
5/20
/07
7/20
/07
9/20
/07
11/2
0/07
1/20
/08
3/20
/08
5/20
/08
7/20
/08
9/20
/08
11/2
0/08
1/20
/09
3/20
/09
5/20
/09
7/20
/09
9/20
/09
11/2
0/09
1/20
/10
PRFZ
IWM
% Difference: (PRFZ - IWM)/PRFZ
-10%
-5%
0%
5%
10%
15%
20%
9/20
/06
11/2
0/06
1/20
/07
3/20
/07
5/20
/07
7/20
/07
9/20
/07
11/2
0/07
1/20
/08
3/20
/08
5/20
/08
7/20
/08
9/20
/08
11/2
0/08
1/20
/09
3/20
/09
5/20
/09
7/20
/09
9/20
/09
11/2
0/09
1/20
/10
18
PRFZ vs Vanguard Small Cap Value (VISVX)
30
40
50
60
70
80
90
100
110
7/13/07
8/13/07
9/13/07
10/13/07
11/13/07
12/13/07
1/13/08
2/13/08
3/13/08
4/13/08
5/13/08
6/13/08
7/13/08
8/13/08
9/13/08
10/13/08
11/13/08
12/13/08
1/13/09
2/13/09
PRFZ
VISVX
The Crash (7/13/07 = 100): PRFZ vs VISVX VISVX (7/13/2007): PRFZ vs
The Recovery (3/09/09 = 100): PRFZ vs VISVX
80
100
120
140
160
180
200
220
240
260
3/9/09
4/9/09
5/9/09
6/9/09
7/9/09
8/9/09
9/9/09
10/9/09
11/9/09
12/9/09
1/9/10
2/9/10
3/9/10
PRFZ
VISVX
Since onset (9/20/06 = 100). PRFZ vs VISVX
40
50
60
70
80
90
100
110
120
130
140
9/20
/06
11/2
0/06
1/20
/07
3/20
/07
5/20
/07
7/20
/07
9/20
/07
11/2
0/07
1/20
/08
3/20
/08
5/20
/08
7/20
/08
9/20
/08
11/2
0/08
1/20
/09
3/20
/09
5/20
/09
7/20
/09
9/20
/09
11/2
0/09
1/20
/10
PRFZ
VISVX
% Difference: (PRFZ - VISVX)/PRFZ
-5%
0%
5%
10%
15%
20%
9/2
0/0
6
11
/20
/06
1/2
0/0
7
3/2
0/0
7
5/2
0/0
7
7/2
0/0
7
9/2
0/0
7
11
/20
/07
1/2
0/0
8
3/2
0/0
8
5/2
0/0
8
7/2
0/0
8
9/2
0/0
8
11
/20
/08
1/2
0/0
9
3/2
0/0
9
5/2
0/0
9
7/2
0/0
9
9/2
0/0
9
11
/20
/09
1/2
0/1
0
19
PRFZ vs Vanguard Midcap Value (VMVIX)
30
40
50
60
70
80
90
100
110
7/13/07
8/13/07
9/13/07
10/13/07
11/13/07
12/13/07
1/13/08
2/13/08
3/13/08
4/13/08
5/13/08
6/13/08
7/13/08
8/13/08
9/13/08
10/13/08
11/13/08
12/13/08
1/13/09
2/13/09
PRFZ
VMVIX
The Crash (7/13/07 = 100): PRFZ vs VMVIX VISVX (7/13/2007): PRFZ vs
The Recovery (3/09/09 = 100): PRFZ vs VMVIX
80
100
120
140
160
180
200
220
240
260
3/9/09
4/9/09
5/9/09
6/9/09
7/9/09
8/9/09
9/9/09
10/9/09
11/9/09
12/9/09
1/9/10
2/9/10
3/9/10
PRFZ
VMVIX
Since onset (9/20/06 = 100). PRFZ vs VMVIX
40
50
60
70
80
90
100
110
120
130
140
9/20
/06
11/2
0/06
1/20
/07
3/20
/07
5/20
/07
7/20
/07
9/20
/07
11/2
0/07
1/20
/08
3/20
/08
5/20
/08
7/20
/08
9/20
/08
11/2
0/08
1/20
/09
3/20
/09
5/20
/09
7/20
/09
9/20
/09
11/2
0/09
1/20
/10
PRFZ
VMVIX
% Difference: (PRFZ - VMVIX)/VMVIX
-10%
-5%
0%
5%
10%
15%
20%
9/2
0/06
11/2
0/0
6
1/2
0/07
3/2
0/07
5/2
0/07
7/2
0/07
9/2
0/07
11/2
0/0
7
1/2
0/08
3/2
0/08
5/2
0/08
7/2
0/08
9/2
0/08
11/2
0/0
8
1/2
0/09
3/2
0/09
5/2
0/09
7/2
0/09
9/2
0/09
11/2
0/0
9
1/2
0/10
20
Table Summary for Small Cap
The fundamental index fund (PRFZ) beat out the other benchmarks over the entire period by 7.2 to 8.0 percentage points in annual return. But, it did it by fairing poorly in the Crash and extraordinarily well in Recovery.
PRFZ bears similar level of risk.
Name of index fund or index Acronym Crash Recovery Since onsetPowerShares FTSE RAFI US 1500 Small-Mid PRFZ -44.6% 155.2% 6.3%iShares Russell 2000 Index IWM -41.5% 98.7% -1.7%Vanguard Small Cap Value Index VISVX -43.9% 116.2% -1.7%Vanguard Mid-Cap Value Index VMVIX -43.4% 107.7% -0.9%
Pow. FTSE RAFI US 1500 Small-Mid dvantage Crash Recovery Since onsetiShares Russell 2000 Index IWM -3.1% 56.5% 8.0%Vanguard Small Cap Value Index VISVX -0.6% 39.0% 8.0%Vanguard Mid-Cap Value Index VMVIX -1.2% 47.5% 7.2%
Volatility of daily returns over entire period (since 9/20/2006).PowerShares FTSE RAFI US 1500 Small-Mid PRFZ 2.14%iShares Russell 2000 Index IWM 2.10%Vanguard Small Cap Value Index VISVX 2.18%Vanguard Mid-Cap Value Index VMVIX 2.02%
Annualized returns
Annualized returns difference
21
Small Cap: Back Testing vs Actuals
The relative performance of the RAFI small cap was very different during the two periods. While in the 28 years of back testing, it excelled at besting the Russell 2000 in Bear markets while recording a smaller advantage in Bull markets; in the actual 3.5 years it faired poorly in the Crash of 2007. But, did extremely well in the Recovery of 2009.
Small U.S. Equities.
Back testing 1979 to 2007 periodBull Bear
Overall Markets MarketsRAFI U.S. Small 16.40% 33.10% -26.70%Russell 2000 12.90% 30.80% -31.90%Advantage 3.50% 2.30% 5.20%
Actual annualized results 9/20/2006 - 3/10/2010Bull Bear
Overall Markets MarketsRAFI U.S. Small 6.30% 155.17% -44.59%Russell 2000 (IWM) -1.73% 98.65% -41.48%Advantage 8.03% 56.51% -3.10%
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A couple of questions…
• Why did the RAFI U.S. 1000 Large Cap did poorly in the Crash of 2007?
• Why did the same fund do so much better than its counterparts in the Recovery of 2009?
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Explanation for poor performance in 2007 Crash: Growth vs Value…
• Large Value oriented index funds (including the RAFI funds) performed worse than traditional index funds during the Crash of 2007.
• Investigating the performance of a growth index fund vs a value index one may be interesting. Let’s look at Vanguard Growth Index (VIGRX) and Vanguard Value Index (VIVAX) that have long historical data going back to 1993.
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Growth vs Value – the Overall Picture
Growth (VIGRX) vs Value (VIVAX) (March 93 = 100)
0
100
200
300
400
500
600
Growth (VIGRX)
Value (VIVAX)
Growth Value
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The Dot.com bust
A Value index being less exposed to the hi-tech sector with high P/E ratio performed much better than a Growth index.
The Dot.com Bust: Growth (VIGRX) vs Value (VIVAX) (March 2000 = 100)
40
60
80
100
120
Growth
Value
Value
Growth
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The 2007 Credit Crash
The 2007 Credit Crash: Growth (VIGRX) vs Value (VIVAX) (October 2007 = 100)
40
60
80
100
120
Growth
Value
Value
Growth
Now, the Value index performed marginally worse. This credit crisis emerged from the financial sector (banks, insurance) that is more prevalent within a Value index including the RAFI US 1000 fund.
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Why did RAFI US 1000 do well in Recovery? Let’s look at sector allocations
VanguardRAFI US Russell Value
1000 1000 VIVAXAs of 12/31/2009 12/31/2009 9/30/2009
Financial services 27.2% 14.4% 25.7%Industrial materials 11.9% 11.0% 14.3%Consumer goods 11.6% 10.6% 8.4%Energy 9.1% 11.2% 16.7%Consumer services 9.1% 8.7% 3.3%Healthcare 5.8% 11.7% 10.3%Hardware 5.3% 11.0% 2.9%Business services 5.1% 4.2% 1.9%Telecommunication 4.8% 5.7% 5.7%Media 4.0% 2.8% 3.5%Utilities 3.3% 3.9% 7.0%Software 2.3% 4.8% 0.2%
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3 key sector allocation differences and performances during the recovery
Sectors in the Recovery (3/09/09 = 100)
100
125
150
175
200
225
250
275Energy
Healthcare
Financials
Healthcare
Energy
Financials
RAFI US 1000 is more heavily invested in Financials that did extremely well and less invested in Energy and Healthcare that did not do as well.
VanguardRAFI US Russell Value
Sector 1000 1000 VIVAXFinancials 27.2% 14.4% 25.7%Energy 9.1% 11.2% 16.7%Healthcare 5.8% 11.7% 10.3%
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Parting thoughts
• The RAFI 1000 Large cap performed poorly during the 2007 Credit Crisis because of its large exposure to Financials. This same exposure to Financials caused it to fare extremely well in the 2009 Recovery.
• Investing in the RAFI 1000 Large cap may entail chronic sector bets including being overweighed in Financials (low P/E sector) and underweighed in Hi tech (high P/E). Such a fund will do well in any hi-tech bubble burst, but not so well in any financial/credit crisis.
• The RAFI 1000 Large cap has a steadier sector allocation than its market cap counterparts because it prevents specific sectors from bubbling.
• So far, there seems to be more than just a Value orientation to such funds.
• A longer actual record will prove informative in fully assessing the relative performance of RAFI funds.
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Reference
Appell, Douglas. (2007). “Fundamental indexing superiority disputed.” Pensions & Investments. April 30, 2007. Available on Internet.
Arnott, Robert D. (2008). “The Fundamental Index.” John Wiley & Sons. Available at public libraries.
Arnott, Robert D. (2005). “Fundamental Indexation.” Financial Analyst Journal. March/April 2005. Available on Internet.
Kaplan, Paul. (2008). “Let’s Not All Become Fundamental Indexers Just Yet.” Morningstar Advisor. Spring 2008. Available on Internet.
Perold, Andre F. (2007). “Fundamentally Flawed Indexing.” Financial Analyst Journal. November/December 2007. Available on Internet.