Earlier this week I discussed the promise of fundamental indexing. This strategy takes aim at the shortcomings of traditional cap-weighted indexes, which overweight growth stocks and are prone to bubbles. In 2005, Rob Arnott and his colleagues unveiled the Research Affiliates Fundamental Indexes (RAFI) and produced data showing that they would have outperformed cap-weighted indexes by about 2% to 3% per year over the long term in almost every market.

Any strategy that can outperform by a couple of percentage points is certainly worth a look. However, the proof is in real-world performance, not in backtested computer models. The question for investors, then, is whether the ETFs and mutual funds based on RAFI indexes have lived up to their billing.

One crucial point before we look at the data. I wasn’t interested in whether the fundamental ETFs have outperformed their cap-weighted counterparts: over a period of five years, this is virtually meaningless. Lots of actively managed funds can make the same claim, but over longer periods, that outperformance generally disappears. So I was more interested in whether the RAFI funds are tracking their own indexes closely.

Cap-weighted index funds are not perfect, but they do have several things going for them: they are cheap and usually have very low tracking errors. The iShares S&P 500 (IVV) has tracked its benchmark within six basis points (0.06%) since its inception more than 11 years ago. In Canada, the iShares S&P/TSX 60 (XIU) has a tracking error of just 0.19% over the same period.

I wanted to know if ETFs based on fundamental indexes could make the same claim. Remember, the data suggest that the RAFI indexes can deliver excess returns of about 2% to 3%. However, higher fees and larger tracking error could easily wipe out that advantage. And fundamental ETFs typically have management fees 20 to 50 basis points higher than their cap-weighted counterparts, and their indexes may be harder for a manager to follow.

The real-world performance

Let’s take a look at the most popular funds based on the RAFI indexes:

  • Since its launch in February 2006, the Claymore Canadian Fundamental ETF (CRQ) has returned 6.37% annualized, versus 7.01% for its index, a difference that’s actually a bit lower than the fund’s MER of 0.69%. Incidentally, it has also outperformed the S&P/TSX 60 over that period and was ranked second out of 93 Canadian Equity funds by Morningstar during its first five years.
  • The Claymore US Fundamental ETF (CLU) and International Fundamental ETF (CIE) have fared much worse. Both lagged their own indexes by huge margins in years past. Part of the reason is that these funds relied on representative sampling rather than owning all 1,000 stocks in the RAFI indexes. The ETFs now own all the stocks in their indexes and they improved their tracking errors in 2010, but both still lagged their benchmarks by more than two percentage points.
  • In the US, the RAFI indexes are licensed by the PowerShares family of ETFs. Since December 2005, the PowerShares FTSE RAFI US 1000 (PRF) has returned 5.03% annually, compared with 5.54% for the index. That shortfall is entirely accounted for by its 0.45% MER. Another good result.

Canadian investors can also get access to the RAFI indexes through mutual funds from Invesco PowerShares. However, these funds are designed to be sold through advisors, so they may have front-end loads and trailer fees added. They typically have MERs in the range of 1.6% to 1.8%. That guarantees that these funds will lag their benchmarks.

Another issue to consider is taxes. If you’re not investing in an RRSP, you’ll receive a tax bill for any capital gains your fund incurred during the year. Cap-weighted ETFs tend to be extremely tax-efficient: the iShares S&P 500 (IVV) has never distributed a capital gain in its 11 years of existence. In Canada, XIU and XIC have done so in the past, although not since 2008. In 2010, both CRQ and CLU also distributed significant capital gains that would have lowered returns for investors holding these funds in a taxable account.

The jury is still out

Fundamental indexing is one of the most important innovations to come along in passive investing. If it were possible to create a mutual fund or ETF that tracked the RAFI indexes within a few basis points, I have little doubt that its long-term performance would be superior to that of a traditional index fund.

But in the end, fundamental indexing must overcome the same hurdles as active management. That is, it must add value after accounting for fees and taxes. So far the results have been encouraging, but it would be hard to argue that investors should expect a 2% to 3% outperformance over the long term. I would expect any outperformance to be less than that because of the added costs of administering the funds. And a poorly run fund would forfeit any advantage at all.

Cap-weighted index funds may be flawed, but they do have at least one thing that fundamental indexes don’t yet have: a long track record of delivering on their promises.