The RAFI explained

RAFI-based products, particularly ETFs, have made a good showing recently and people want to know more about them.

RAFI stands for “Research Affiliates Fundamental Indexation”. Research Affiliates is a California-based financial services company that has registered worldwide the patent for fundamental indexation. In South Africa, FTSE/JSE and Plexus Asset Management have license agreements with the company.

The RAFI is unusual because it weights shares based on sales, cash flows, book prices and dividends (in other words, relative valuations). Local RAFI indices are based on a five-year survey of the accounting data of the Top 100 companies on the JSE (an index is made up of 40 of the top 100 local companies based on this method).

Investing with the RAFI has been called an investment strategy, because these products are more like a “value fund” — identifying which shares offer value. They don’t rely on size, performance and liquidity, so the larger market cap index is skirted.

Also, RAFI is adjusted annually in the case of the FTSE/JSE-RAFI licence, and quarterly in the case of enhanced RAFI products, so these are not actively managed funds. The costs are a bit lower than those of active funds as a result. And because RAFI funds have outperformed the average return of the unit trust industry over the past three years, RAFI technology is attracting investors.

The Old Mutual RAFI 40, for example, has shown a total return of 4,25% a year over three years to end of October 2010, in contrast to the FTSE/JSE Top40 Index, which has shown a 1,09% a year return. The Satrix RAFI 40 has shown 16,37% over a year, marginally ahead of the 15,98% shown by the FTSE/JSE Top40 Index, all to the end of October 2010.

According to Helena Conradie, head of Sanlam Investment Management’s (SIM) equity index tracking business, sim.smartcore, the RAFI forms part of a new breed of smart beta products.

“Investors are increasingly looking for superior outperformance with lower fees. By investing in smart beta indices investors can access smarter trackers that are more cost effective than active management funds,” she says. “The RAFI’s alternative weighting scheme gives the investor a more realistic exposure to the economic reality of the underlying market than a market cap weighted index.”

ETF products available in South Africa include the Satrix RAFI 40 and NewFunds eRAFITM (Overall, Industrial 25, Financial 15, Resources 20) and, on the unit trusts side, Old Mutual RAFI 40 Tracker and Plexus Enhanced Strategy Fund.

The eRAFI TM[trademark] is a joint initiative between Absa Capital and Plexus Asset Management. According to Paul Stewart, managing director at Plexus, RAFI is a solid bet. “Detractors have argued that RAFI has produced its outperformance only by assuming more risk or taking a small-cap value bet — a bias inherent in the types of shares selected by means of the RAFI methodology. But over time RAFI beat most value indices too, so something else is at play,” he argues.

That “‘something” may be worth investigation. Just educate yourself about your exposure to risk and be sure to diversify your portfolio. If you’re looking for a different fund, the RAFI may be a good option.

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