This new video from Research Affiliates uses charts, graphics, and animation to explain the Research Affiliates Fundamental Index or “RAFI.” It tells the story of how Research Affiliates co-founders Rob Arnott and Jason Hsu developed RAFI, how RAFI works, and why it’s outperformed the S&P 500 by 1.5% to 2% per year.
Market-cap weighting inherently overweights overvalued stocks and underweights undervalued ones. RAFI, by contrast, uses fundamental factors to weigh holdings according to companies’ macro-economic size. When a stock becomes overvalued relative to their fundamentals, RAFI reduces its holdings of the stock. When a stock is relatively undervalued, then RAFI increases its holdings. The RAFI is balanced across sectors, and the approach can also be used for small-cap, non-U.S. and emerging-market stocks.