Rob Arnott, RAFI’s designer, describes the basic model as “dumb”, meaning that it is a purely passive index. Research Affiliates and Informed Portfolio Management (IPM), the Stockholm based arm of First Quadrant, have since introduced a “smart ” or enhanced version of RAFI to show what a little judicious tweaking can achieve.

Enhanced RAFI is designed to top up the performance of basic RAFI, which delivers returns of 2% above cap-weighted indexes. “Using the enhanced vision generates value added on top of passive RAFI, we can add 80 to 100 bps,” says Martin Mansson, the marketing director of IPM.”The important thing is that volatility is kept at exactly the same level.”

The enhancement is done on three levels, simultaneously. At the first level the objective is to adjust for a true fundamental weight. This is done by adding two quantitative screens - net operating assets to assess quality of earnings and the debt coverage ratio to identify financial distress risk.

The screens are applied uniformly across all markets. “The effect is to reduce the risk/weight of low quality companies and failures while at the same time increasing the weight of prudent or good quality companies,” says Mansson. “It also reduces the volatility.”

At the second level, the factor weights are optimised. Standard RAFI uses equal-weighting of the four factors (sales, profit, book value and dividend ) to determine fundamental size. Enhanced RAFI takes account of the fact that the predictive power of these four factors - that is, their usefulness in recognising a company’s strength or growth prospects - will vary from country to country.

“There are accounting differences, cultural differences and fiscal differences which all go to explain why some factors are more important than in some countries rather than another,” says Mansson. Enhanced RAFI therefore uses non-equal weights, which will vary between the different markets.

At the third level, there is a dynamic re-weighting of the RAFI universe and active re-balancing of the weights. While standard RAFI re-weights the constituents of the index once a year, enhanced RAFI re-weights more frequently, typically every quarter. ” This gives the possibility of updating the index database continuously and dynamically,” says Mansson. “Obviously, corporate actions happen throughout the year and they affect the fundament values of the constituents.”

Yet the more frequent re-balancing of the portfolio is done with an eye on transaction costs, he adds. “We don’t engage in full re-balancing but rather intelligent rebalancing to minimise trading costs and portfolio turnover.”

Dynamic re-weighting and active re-balancing are both improvements of the methodology of standard RAFI, he says, since they use the most recently published, real time information. They reduces ‘drift’ and track more closely the true RAFI weights.

The effects have been measurable in terms of added returns, says Mansson. A historical retrospective of returns in the US between 1962 and 2006 shows that enhanced RAFI has outperformed standard RAFI in every decade (see Table). In the 1970s by 80 basis points, in the 1980s by 70 basis points, in the 1990s by 50 basis points and in 2000 to 2006 by 140 basis points. In three of these periods - the 1970s , 1980s and from 2000 to 2006, enhanced RAFI returned more than 2% above the
S &P 500.

The amount invested in fundamental indexes has grown from $100m (€78m) at the beginning of last year to $4bn currently and is expected to grow to between $7bn and $10bn by the end of the year. Assets indexed to cap-weighted indexes total some $5 trn.

Jonas Rinné, managing partner of IPM, says concerns about duration have raised interest in fundamental indexing in Europe: “It’s gaining tremendous traction in the European marketplace, and we think that the need to bridging the gap between assets and liabilities is probably the most important driver for this.

“Using fundamental indexes means that you can actually lower absolute nominal volatility in an equity investment, which means that you can invest more of your risk budget into equities. You can actually bridge that gap by a 50% longer duration.”