research affiliates, fundamental index overview

Does Finance Theory Lead Us Astray? The Fundamentals of the

Fundamental Index® Concept

IQPC Indexing Strategies Asia 2007November 28, 2007

Hong Kong

Rob Arnott / [email protected]

For Educational Use Only

This presentation was created by Research Affiliates. This presentation contains the current opinions of the presenter, which are subject to change without notice. This

presentation does not represent a recommendation of any particular security, strategy or investment product.

2 For broker/dealer information only

Important Information

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The material contained in this document is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. Research Affiliates and its related entities do not warrant the accuracy of the information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this material should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Any information and data pertaining to indexes contained in this document relates only to the index itself and not to any asset management product based on the index. No allowance has been made for trading costs, management fees, or other costs associated with asset management as the information provided relates only to the index itself. With the exception of data on Research Affiliates Fundamental Indexes, all other information and data are based on information and data available from public sources.

Any inquiries relating to the transactions should be directed to Research Affiliates, LLC.

The trade names Fundamental Index, Fundamental Indexing, RAFI, RAFI-Global, Fundamental Global, Fundamental K, Fundamental Q, Fundamental REIT, Fundamental 100, Fundamental 200, Fundamental 250, Fundamental 1000, Fundamental 2000, Fundamental 3000, Global Fundamental, Research Affiliates, Mainstreet Index, Mainstreet Indexing, Synthetic Strips, Virtual Mutual Fund, the RAFI logo and the Research Affiliates corporate name and logo are the exclusive intellectual property of Research Affiliates, LLC. Any use of these trade names and logos without the prior written permission of Research Affiliates, LLC is expressly prohibited. Research Affiliates, LLC reserves the right to take any and all necessary action to preserve all of its rights, title and interest in and to these terms and logos.

Fundamental Index™, the non-capitalization method for creating and weighting of an index of securities, is the patent-pending proprietary intellectual property of Research Affiliates, LLC (Patent Pending. Publ. Nos. US-2005-0171884-A1, US-2006-0015433-A1 and WO 2005/076812).


Why Index?

Access market returns at low cost

Most active managers don’t beat index returns

■ It’s very hard to pick the winning managers (or stocks)

Favorable portfolio attributes

■ Large investment capacity

■ Low fees and expenses

■ Diversification

■ Broad market exposures


Index vs. Active Management: U.S. Market

10 Years 20 Years

S&P 500 Index 9.07% 11.94%

Average Equity Fund* 7.62% 10.54%

S&P 500 Advantage

(percentage points)1.45% 1.40%

*Consists of ALL Lipper equity categories.

Performance data quoted represents past performance and does not indicate future results.

Source: Lipper, Wilshire, and the Vanguard Group. Time periods ending 31 December 2005.


Index vs. Active Management: Global Markets

International

■ 69% of active managers underperformed (241 funds vs. MSCI World)

Europe

■ 86% of active managers underperformed (154 funds vs. MSCI Europe)

Emerging Markets

■ 76% of active managers underperformed (129 funds vs. MSCI Emerging Markets)

Universe: Emerging Markets active equity funds registered in Austria, Belgium, France, Germany, Ireland, Italy, Luxembourg, Portugal, Spain, Switzerland, The Netherlands, United Kingdom, and Offshore.

Time Period: 10 years ending 31 December 2005 for International and Europe; 5 years ending 31 December 2005 for Emerging Markets.

Source: Lipper, MSCI, and the Vanguard Group


Why are Cap-Weighted Indexes So Very Dominant?

The markets are cap-weighted

■ To own a portfolio that mirrors the market, we must cap-weight

Rooted in theory

■ Based on Efficient Market Hypotheses (price efficient in markets)

■ In equilibrium, the cap-weighted market portfolio is optimal

Practical benefits

■ Success of S&P 500 set example for others to follow

■ Inexpensive way to gain exposure to market returns

■ Allocation self-adjusts with price movement

■ Positive attributes: liquidity, capacity, low cost

Empirical performance

■ Vulnerable to pricing bubbles and subsequent corrections

Our Biggest Bets are in Equities –Is Theory Leading Us Astray Here?


The Return Drag of Cap-Weighting

The Efficient Markets Hypothesis

� Price identically equals true fair value for all assets at all times

� Hardly anyone believes this

If price equals true fair value plus or minus an error …

� Overvalued will have higher market capitalization and higher valuation multiples than they should

� This creates the size and value effects

How likely is it that the top ten in market cap and the top ten in true fair value will be the same stocks?

� Some of the top market cap get there through pricing error

� None get there as a consequence of being undervalued!


Source: Research Affiliates

How Much Performance Drag Can You Stand from Owning The Top 10 Stocks?

–37.0%–24.9%–15.9%–3.6%1964 – 2006

–29.4%–17.7%–11.0%–2.9%1926 – 2006

10-Year5-Year3-Year1-Year

By How Much Did the Top 10 Stocks Underperform the Average?

27%30%35%38%1964 – 2006

31%37%40%44%1926 – 2006

10-Year5-Year3-Year1-Year

How Often Did the Top 10 Stocks in the S&P 500 Outperform the Average Stock (S&P 500 EW) in the Years that Followed?


Problems with Cap IndexesProblems with Cap Indexes

Introduces substantial growth bias

Fully participates in every market bubble

Fully participates in every market decline

Stocks selected by a committee (S&P, MSCI)

■ Or by formulas which are closely-guarded secrets

Most turnover is in the smallest names

But the most important problem—

Over weights all over priced stocks

Under weights all under priced stocks

Can We Improve on Cap-Weighting?


The Fundamental Index™ Concept

Main Street uses fundamentals:■ Income or cash flow

■ Sales or revenues

■ Book equity value (shareholders’ equity)

■ Gross dividends paid

Creating an index based on “fundamentals”■ An equity index of 1000 stocks

■ Companies selected by fundamentals

■ Companies ranked by fundamentals

■ Companies weighted by fundamentals

This a valuation-indifferent index■ Strips away linkage between portfolio weight and any

over- or under-valuation


RAFI Outperforms with Lower Volatility

Results are based on RA research. Hypothetical or simulated performance results have certain inherent limitations. Unlike actual performance records, simulated results do not represent actual trading.

Source: Bloomberg and Research Affiliates, LLC.

1962–2006

Ending

Value of $1

Annual

Return Volatility Sharpe Ratio

Excess Return vs.

Cap 1000

Excess

Return

t -statistic

S&P 500 85 10.38% 14.74% 0.37 0.08% 0.31

Cap 1000 82 10.30% 14.95% 0.36 0.00% —

Book 177 12.19% 14.64% 0.48 1.89% 3.63

Cash Flow 207 12.59% 14.65% 0.51 2.28% 3.96

Sales 240 12.95% 15.53% 0.51 2.65% 3.67

Gross Dividend 166 12.04% 13.39% 0.50 1.73% 2.25

RAFI™ Composite 201 12.50% 14.48% 0.51 2.20% 3.66


US Fundamental Index 1000 vs. Cap Weighted US 1000

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$220

Dec-61 Dec-70 Dec-79 Dec-88 Dec-97 Dec-06

RAFI™ US 1000 Cap Weighted US 1000

Comparison of Indexes

15 For broker/dealer information onlySource: Research Affiliates, LLC

RAFI™ vs. Reference Cap 1000: Rolling 5-Year Annualized Returns

For the period 12/31/1966 – 12/31/2006

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Reference Cap 1000 - Rolling 5 Year Return

RA

FI -

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llin

g 5

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Retu

rn


Fundamental Index Concept: “Next 2000”

Adds twice as much value as R2V, despite only one-fourth the value tilt.

Source: Research Affiliates, LLC.

Composition andSector Allocation Stability


Twenty Largest Holdings on 12 / 31 / 2006Twenty Largest Holdings on 12 / 31 / 2006

Company Weight Company Weight

1 Exxon Mobil Corp 2.95% 1 Exxon Mobil Corp 3.26%2 General Electric 2.53% 2 General Electric Co 2.72%3 Citigroup 2.11% 3 Citigroup Inc 1.95%4 Microsoft Corp 1.68% 4 Microsoft Corp 1.87%5 Bank of America 1.65% 5 Bank of America Corp 1.72%6 Chevron 1.61% 6 Procter & Gamble Co 1.49%7 JPMorgan Chase & Co 1.49% 7 Johnson & Johnson 1.38%8 General Motors Corp 1.48% 8 Pfizer Inc 1.34%9 Altria Group 1.43% 9 Altria Group Inc 1.26%

10 AT&T 1.40% 10 JPMorgan Chase & Co 1.18%11 Verizon Communications 1.35% 11 Cisco Systems Inc 1.18%12 Wal-Mart Stores 1.33% 12 Chevron Corp 1.15%13 Pfizer 1.08% 13 American International Group Inc 1.11%14 Berkshire Hathaway 1.01% 14 IBM Corp 1.06%15 American Intl Group 0.92% 15 AT&T Inc 0.98%16 Merck & Co 0.92% 16 Wells Fargo & Co 0.84%17 Ford Motor 0.88% 17 ConocoPhillips 0.84%18 Johnson & Johnson 0.83% 18 Intel Corp 0.83%19 International Bus Machns. 0.82% 19 Hewlett-Packard Co 0.81%20 Wells Fargo & Company 0.77% 20 Wal-Mart Stores Inc 0.80%

Russell 1000FTSE RAFI 1000

Source: Research Affiliates, LLC


Rotation in the Top 10, Cap Weighted

CAP WEIGHTING, TOP 10 LISTS, 1/1965-1/2007

Rank Jan-65 Jan-70 Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-07 Fallen Angels

1 T/SBC IBM T/SBC IBM IBM XON/XOM GE MSFT GE XOM 26

2 GM T/SBC IBM T/SBC XON/XOM GE T GE XOM GE Changes:

3 J/XOM GM J/XOM XON/XOM GE IBM XON/XOM CSCO C C 30

4 IBM EK EK GM GM T/SBC KO WMT MSFT MSFT Flip/Flops:

5 TX/CVX J/XOM GM SN/AN T/SBC MO MO XOM PFE BAC 15

6 DD S S MOB/XOM SUO MRK WMT INTC BAC PG Leads RAFI:

7 S TX/CVX PG GE SN/AN BMY MRK LU JNJ JNJ 23

8 GE XRX GE SD/CVX DD DD IBM IBM IBM PFE Lags RAFI:

9 GO/CVX GE SN/AN ARC/AN S SN/AN PG C AIG MO 41

10 EK GO/CVX TX/CVX SUO EK BLS DD AOL INTC JPM

Green = New to top 10 Red = Falling off top 10 Blue = Flip/Flop



Rotation in the Top 10, RAFI

FUNDAMENTAL INDEXING, TOP 10 LISTS, 1/1965-1/2007

Rank Jan-65 Jan-70 Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-07 Fallen Angels

1 GM T/SBC T/SBC T/SBC T/SBC XON/XOM XON/XOM XOM XOM XOM 10

2 T/SBC GM GM GM XON/XOM IBM IBM F C GE Changes:

3 J/XOM J/XOM J/XOM XON/XOM IBM GM GM GE GE C 17

4 F F IBM IBM GM F F GM WMT MSFT Flip/Flops:

5 TX/CVX IBM TX/CVX MOB/XOM MOB/XOM T/SBC GE C FNM BAC 2

6 DD TX/CVX F F TX/CVX MOB/XOM T/SBC T/SBC BAC WMT Leads CAP:

7 GE GO/CVX GO/CVX TX/CVX SN/AN GE MOB/XOM MO T/SBC VZ 41

8 S MOB/XOM MOB/XOM GE CHV/CVX DD MO FNM CVX CVX Lags CAP:

9 IBM GE SD/CVX GO/CVX GE CHV/CVX DD WCOM GM MO 23

10 SD/CVX S S SD/CVX DD SN/AN CHV/CVX IBM AIG PFE

Green = New to top 10 Red = Falling off top 10 Blue = Flip/Flop



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1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006

Po

rtfo

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ap

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hte

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Retail

Non-Dur

Chem

Health

Finance

Energy

Dur

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Elec. Eq.

Telcom

Util

Other

Sector Weights Over Time,Capitalization Weighting



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1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006

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Retail

Non-Dur

Chem

Health

Finance

Energy

Dur

Manu

Elec. Eq.

Telcom

Util

Other

Sector Weights Over Time,Fundamental (Composite) Weighting


How Well Does the Fundamental Index™ Concept

Work Outside of the US?


Fundamental Index™ International1983-2006 Cumulative Performance

$0.0

$5.0

$10.0

$15.0

$20.0

$25.0

$30.0

Dec-83 Dec-85 Dec-87 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05

RAFI™ International FTSE All World ex US FTSE All World ex US Value



How Well Does Fundamental Index™ Work Globally?


Country

RAFI™

Return

MSCI

Return

Excess

Return

Tracking

Error Info Ratio

Excess

Return t-

stat

Start

Date

Ireland 20.1% 12.1% 8.1% 8.48% 0.95 4.15 1988

Austria 18.4% 13.5% 4.9% 8.87% 0.56 2.67 1984

Norway 17.7% 13.2% 4.6% 6.08% 0.75 3.61 1984

France 17.3% 13.4% 3.9% 6.72% 0.59 2.81 1984

Singapore 12.8% 9.0% 3.7% 6.09% 0.61 2.68 1988Portugal 12.5% 9.1% 3.5% 7.91% 0.44 1.86 1989Spain 17.2% 13.8% 3.4% 4.82% 0.72 3.13 1988Hong Kong 21.0% 17.6% 3.4% 5.80% 0.59 2.81 1984

United Kingdom 15.3% 12.3% 3.0% 4.12% 0.73 3.50 1984Germany 13.4% 10.4% 3.0% 5.62% 0.53 2.55 1984Canada 13.7% 10.7% 3.0% 6.54% 0.45 2.17 1984

Japan 7.9% 5.0% 2.9% 5.21% 0.56 2.68 1984

United States 13.7% 10.8% 2.9% 4.51% 0.64 3.06 1970Italy 16.3% 13.9% 2.4% 5.27% 0.45 2.15 1984Australia 16.0% 13.7% 2.2% 4.90% 0.45 2.18 1984Greece 22.0% 19.9% 2.1% 7.40% 0.28 1.21 1989Sweden 18.0% 16.0% 2.1% 9.40% 0.22 1.05 1984Denmark 13.0% 11.1% 1.9% 7.78% 0.25 1.18 1984

Finland 15.6% 13.8% 1.8% 20.70% 0.09 0.39 1988

Belgium 16.7% 15.3% 1.4% 5.03% 0.27 1.31 1984

Netherlands 14.0% 13.0% 1.1% 6.04% 0.18 0.86 1984

New Zealand 7.6% 7.2% 0.4% 8.48% 0.05 0.20 1988

Switzerland 12.2% 12.6% -0.4% 4.06% -0.10 -0.48 198423-Country Average 14.9% 11.8% 3.1% 2.67% 1.17 5.64 1984

23 Country Return Statistics through December 2006


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Other Developed Other G6 United States

For Cap Returns > 30%,

RAFI™ adds value in

41% of all cases

For Cap Return 20-30%,

RAFI™ adds value in 63%





of all cases

For Cap Return < 0%,


of all cases

RAFI™ vs. Reference CapRolling 5-Year Returns, 23 Countries



Fundamental Index™ Japan1983-2006 Cumulative Performance

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

$6.0


RAFI™ Japan FTSE Japan FTSE Japan Value



RAFI Asia ex Japan Performance

Cumulative Performance of $1 Invested in 1989

Just Another Value Index?


Dynamic Attribution Analysis of RAFI Returns

RAFI International (1984-June 2007) RAFI 1000 (1962-June 2007)

Total Value Added 3.50% Total Value Added 2.12%

Sector Allocation 0.33% Sector Allocation 0.50%

Static Value Added -0.02% Static Value Added -0.05%

Dynamic Value Added 0.35% Dynamic Value Added 0.54%

Value Tilt 1.68% Value Tilt 1.03%

Static Value Added 0.98% Static Value Added 0.53%


Size Tilt 0.46% Size Tilt 0.33%

Static Value Added 0.24% Static Value Added 0.13%


Stock Selection 0.22% Stock Selection 0.26%

Country Allocation 0.80%

Static Value Added 0.19%

Dynamic Value Added 0.62%


RAFI Beats Value but Looks Like S&P

Hypothetical or simulated performance results have certain inherent limitations. Unlike actual performance records, simulated results do not represent actual trading.


RAFI® 1000 vs S&P 500 and Russell 1000 Value

(1979-June 2007)

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10

20

30

40

50

60

70

Jan-79 Jan-84 Jan-89 Jan-94 Jan-99 Jan-04

RAFI® 1000 S&P 500 Russell 1000 Value

Return Volatility

Value

Add Beta Correl

RAFI® 1000 15.7% 14.1% 2.3% 0.92 0.96Russell 1000 Value 14.4% 13.8% 1.0% 0.88 0.94

S&P 500 13.4% 14.8%


RAFI Exposure to Value is Dynamic

Value Tilt of RAFI US Large is Most Pronounced When Value is Beating Growth, and Modest When Growth is Beating Value

Value Tilt–Rolling regression coefficient of RAFI US Large against [Russell 1000 Value minus Russell 1000 Growth]/2


0.25

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Jan-79 Jan-81 Jan-83 Jan-85 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07

0.25

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10-Year Growth vs Value Relative Performance, Left Scale RAFI™ Value Tilt vs Russell 1000 Value Index, Right Scale

How Well Does the Fundamental Indexing™ Concept Work in

the “Less Price Efficient” Space?


Fundamental Index™ Emerging Markets1987-2005 Cumulative Performance

0.0

1.0

2.0

3.0

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5.0

6.0

7.0


RAFI EM USD FTSE AW EMG FTSE EM Value *

Adds 1000 bp per annum, despite the fact that value hasn’t worked in EM.


Are We Blinded by Theory?

Theory does a Marvelous Job explaining how the world ought to work

Theories are sometimes provable, based on certain assumptions

Gaps between theory and reality are normal

Still, some observers cling to theory as fact

■ Assume a theory is correct description of reality

■ Assume that, therefore, the assumptions are correct

■ This is exactly backwards!


Enough of the Past …How about the Future?

Paul Samuelson:

“Only the smallest fraction of economic writings, theoretical and applied, has been concerned with the derivation of operationally meaningful theorems. In part at least, this has been the result of the bad preconception that economic laws deduced from a priori assumptions possessed rigor and validity independently of any empirical human behavior. But only very few economists have gone so far as this. The majority would have been glad to enunciate meaningful theorems if any had occurred to them.”

1. Theory is not fact. It describes an ideal world.

2. Empirical data which contradicts theory may be right.

3. Theory is improved by acknowledging its flaws and findingimprovement, not by rejecting contradictory evidence.

research affiliates, fundamental index overview

Economy & Finance

active managers

represent

simulated

fundamental

simulated

active management

2006 cumulative

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