Should price wag value or vice versa, RAFI strategies...

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grap0013
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Should price wag value or vice versa, RAFI strategies...

Post by grap0013 »

I was already sold on the RAFI strategy because it seems more contrarian than any other current available strategy available. Such as cap weighting. I had read most of the stuff on the research affiliates website, but I decided I'd better buck up and read the book too since I am starting to have some considerable assets devoted to this strategy as I'm full monty with it.

With that being said, a couple of things jumped out at me from the book that I hadn't thought of in such detail previously. One part talks about which of the two "revolves" around the other. Does price determine value or does value determine price? Which one wags the other? Price seems like the superficial and easy answer as it is transparent. However, determining the true intrinsic value of something is much more difficult. Just because a car looks great on the outside (price) doesn't tell you a whole lot about the what's under the hood (value). I think "guessing" at an intrisic value is a better method than traditional cap weighting.

I thought the RAFI strategy was effective due to the specific sorts it use such as P/B, P/E, P/CF, and P/D. However, the key to it, as the authors claim, is severing the link between the weight of a stock in the index and its price. The speficic sorts don't really matter all that much.

Something else that surprised me was the degree to which the RAFI strategy is formulaic and replicable. It's not a stock picking strategy and the backtests look legit. For instance the backtest of RAFI small beat the VG SCV by about a full 2% annualized over the past 30 years. I'd wager it will continue outperforming into the future. If the costs were ridiculous I wouldn't take the gamble, but I think 25 extra basis points is well worth a shot. Think about VBR for a minute. Since it's cap weighted it gives the highest weighting to the most expensive small cap value stocks. So basically it overweights the growthiest small cap value stocks. RAFI small severs this link and that's why I believe it's more likely to deliver returns closer to FF SCV than VBR is.

Maybe it all comes down to your belief in efficient markets. Rafi believes in inefficient markets and cap weighting does. If all markets were truly efficient wouldn't the stock market just go up by 0.04% per day to work out to be about 10% annualized? Does that much really happen on a day to day basis in a single company to garner the volatility of the price that comes with it? It's not like every company is reporting earnings every single day.

For those of you that dis the RAFI strategy I challenge you to read the book before you come to conclusions. I think some people have cap weighting so thoroughly ingrained in their core being that an alternative strategy is considered inconceivable before it's even explored. Remember cap weighting used to be nonconventional not that long ago...

One final note, it interesting to me that some people will debate at nausem about small differences in ERs in money market accounts with 2K in them, but won't take the time to learn if other potential options may better suite their big picture investing needs/wants.

Feel free to attack, comment, answer, any or all of the above. Or if the book changed your view on fundamental indexes.
Last edited by grap0013 on Thu Jan 27, 2011 11:10 pm, edited 1 time in total.
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Post by BlueEars »

Did I miss it or does this book have a title? :)
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Re: Should price wag value or vice versa, RAFI strategies...

Post by caklim00 »

grap0013 wrote:Think about VBR for a minute. Since it's cap weighted it gives the highest weighting to the most expensive small cap value stocks. So basically it overweights the growiest small cap value stocks. RAFI small severs this link and that's why I believe it's more likely to deliver returns closer to FF SCV than VBR is.
Agree, but then if this is the primary concern why don't you just use the Pure Value series ETFs (for domestic)? These are Value sorted not Cap Weighted and will give more pure FF loading*

For the record, I am a holder of the following Value tilted funds
Cap Weighted
VBR, DFFVX

Fundamental Indexes
RZV (can I call this a FI?), SFILX, DLS, DGS

Personally, I'm betting I will side with Russell Ex-US SCV when it comes out. But, that's not to say that I didn't find the argument for RAFI compelling: http://www.researchaffiliates.com/ideas ... 201007.pdf

This article basically suggests that you can time the Value premium. Oh where is Larry S. when you need him :D
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Post by grap0013 »

Les wrote:Did I miss it or does this book have a title? :)
Whoops, here ya go. The Fundamental Index. It is a must read IMO.
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Re: Should price wag value or vice versa, RAFI strategies...

Post by ScottW »

grap0013 wrote:Think about VBR for a minute. Since it's cap weighted it gives the highest weighting to the most expensive small cap value stocks. So basically it overweights the growiest small cap value stocks.
I never understood this logic. Take two companies: "A" has $1 million in annual earnings, while "B" brings in $100 million. Both have been growing at the rate of 5% a year.

Company A has a market value of $50 million (50x earnings). Company B's value is $150 million (1.5x earnings). According to the logic above, company B is more "expensive" and "growthy".

Market value alone is virtually useless--it must be viewed in context with other factors for it to be meaningful.
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Re: Should price wag value or vice versa, RAFI strategies...

Post by grap0013 »

ScottW wrote:
grap0013 wrote:Think about VBR for a minute. Since it's cap weighted it gives the highest weighting to the most expensive small cap value stocks. So basically it overweights the growiest small cap value stocks.
I never understood this logic. Take two companies: "A" has $1 million in annual earnings, while "B" brings in $100 million. Both have been growing at the rate of 5% a year.

Company A has a market value of $50 million (50x earnings). Company B's value is $150 million (1.5x earnings). According to the logic above, company B is more "expensive" and "growthy".

Market value alone is virtually useless--it must be viewed in context with other factors for it to be meaningful.
Right, that's why the fundamental index divides cap weight by the average score of the value metrics I mentioned in the opening post. It takes it all into account.
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Post by stlutz »

The RAFI indices have at least a theoretical appeal to me. It's never really made sense to me that because everyone else owns 10x as much of company A than company B, that I must therefore do so. For that reason, equal-weighted indexes (at least in the large cap space) have appeal for me. Unfortunately, the tracking error for Rydex's RSP ETF has been about .6% per year, which is too big for my tastes. If Rydex would Vanguard their expense ratio, I'd probably invest.

RAFI does have some sense as well. If a company is economically twice as big, I'd buy twice as much--weight the economy as opposed to the market.

In discussions like these, I think it's probably not helpful to compare RAFI vs. "tilting". The idea behind tilting is that you always want to overweight undervalued companies because they will most likely do better (either because they are higher risk or for predictable behavioral reasons). RAFI is factor indifferent. When a segment of the market is way overvalued, as tech stocks were in 2000, it will have a relatively lower weighting of those, and could thus be considered "tilted." However, when you do not have those types of significant over/undervaluation, RAFI really won't have much "tilt" to it at all. That is one advantage to RAFI, I think--it's "tilt" is variable based on market conditions as opposed to being a strategy of betting on "undervalued" stocks.

However, the construction of the indexes concerns me somewhat. Are dividends really a measure of economic importance? Their choice of metrics to include makes me wonder if they data-mined the combination of factors that produced the best historical returns as opposed to constructing the indexes based on what objectively measures economic importance.

From a practical perspective, it seems that the large-cap US funds have been the only ones that have not had negative tracking error issues (at least with the Schwab funds), so that is the only one that really interests me at the moment (not enough to actually commit cash however).
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Post by grap0013 »

stlutz wrote: However, the construction of the indexes concerns me somewhat. Are dividends really a measure of economic importance? Their choice of metrics to include makes me wonder if they data-mined the combination of factors that produced the best historical returns as opposed to constructing the indexes based on what objectively measures economic importance.
I've read Swedroe say that a dividend strategy is a value strategy, but it's a poor one. I've seen Ferri write about the other 3 factors as being historic measures of value stocks. So I don't think their selection was blindly drawing traits out of a hat or complete mining.

It's interesting Rafi has a dynamic value shift from a cap perspective, but from a fundamental perspective it's more like "fair value" weighing and has no tilt whatsoever. Each year every stock is balanced back to its intrinsic value.

Actually both Powershares and Schwab look like they're tracking well on both large/small for the U.S. side of things, but the international tracking error bothers me a little. I'm not sure if they're still working out the kinks or what. The emerging market fund has trailed its benchmark by roughly 2.5% annualized since inception. I'm not sure why they just don't use a full replication approach as I see the index does not have that many more stocks than the fund.
Last edited by grap0013 on Thu Jan 27, 2011 11:13 pm, edited 1 time in total.
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Re: Should price wag value or vice versa, RAFI strategies...

Post by grap0013 »

caklim00 wrote:[Agree, but then if this is the primary concern why don't you just use the Pure Value series ETFs (for domestic)? These are Value sorted not Cap Weighted and will give more pure FF loading*

For the record, I am a holder of the following Value tilted funds
Cap Weighted
VBR, DFFVX

Fundamental Indexes
RZV (can I call this a FI?), SFILX, DLS, DGS

Personally, I'm betting I will side with Russell Ex-US SCV when it comes out.
If RZV just had more stocks I'd use it. I think I can achieve the same returns as RZV with SFSNX/PRFZ at a fraction of the volatility. I think that Russell fund is gonna be sweet!
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Post by stlutz »

RAFI and equal-weight indices make more sense than RZV for those who think more in terms of investing in companies than in "factors". For me the ideal fund would be a market-cap weighted total-market fund, but with the following modifications:

a) No stock will be more than .5% of the fund--I don't want my performance determined by 50 stocks. Equal-weighting these mega-cap companies doesn't really add much to costs since they are so liquid.
b) No sector will be less than 5% or more than 15% of the portfolio. Again, I want diversified holdings with broad economic exposure.
c) I'd want portfolio turnover of less than 25% for all of the reasons we always talk about here.

Obviously, there would need to be some compromise between these three rules, so the fund would sort of be an actively-managed passive fund.

For international, I'd add one more rule:

d) The largest country-weighting will be no greater than the second-largest country weighting. Again, this avoids the problem of one country dominating returns as occurred with Japan in the 80s.

If we just had a domestic and and int'l fund like that, I could have a three-fund portfolio, all without all of the RAFI complexity!
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Post by cheapskate »

RAFI is an excellent choice. In the relatively short time it has been around, it has proven a worthy competitor to DFA. Great news for us DIYers. I like the formulaic contra-trading inherent in the RAFI strategy, which will lead to selling expensive stocks and buying cheap ones.

The attack against RAFI can be summarized thus

1) It is not an Index.
(Who cares ? It is a widely diversified, formulaic quant strategy that can be implemented at relatively low cost).
2) It is value and small/mid tilting in a different guise.
(Mostly true, but why does this make it a bad strategy ?)
3) It is high turnover.
(This has not been the case in practice, from what I have seen).
4) Tax Inefficient.
(Not true from what I read).
5) High cost.
(Costs for RAFI are no higher than DFA, before factoring in advisor fees. It remains to be see if RA raises their licensing fees as the strategies become more popular. Have to wait and watch).
6) Tracking errors.
(Have gone down significantly as assets have grown).
7) Rob Arnott's obnoxious marketing.
(Valid issue :))

I don't own any RAFI funds at the moment, but I do plan to direct new equity money to RAFI/Schwab.
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Post by Kenster1 »

Yes Larry likes deep value or low P/B to access the deeper value premium. But based on P/B, the Wisdomtree ETFs are in very similar ranges to the standard indexes. So Larry is right in that the Wisdomtree indexes are not nearly as valuey at all to the value indexes --- in fact, many of the Wisdomtree have the same P/B ratios as the standard (blend) indexes. So there are some misconceptions by many others who simply say that the Wisdomtree indexes may outperform purely due to higher risk from the value tilt.

Their benefit that they are promoting is really the higher dividends and the reconstitution. The reconstitution will do a bit of a buy-low, sell-high rebalance similar to Arnott's Fundamental Index but instead of it being based on 4 fundamental factors, it is based on the one single dividend factor.

Here are the characteristics for the Wisdomtree ETFs incuding P/E, P/B, P/S, etc.

http://www.wisdomtree.com/library/pdf/i ... 10-711.pdf

Example:

Say CompanyX is in position 100 in both the mkt-weighted and fundamental weighted index. And over a year's period, CompanyX invested a lot of money on marketing and hyping up their products and services and had caught the eye of investors who bought and bid up their stock price.

Say over this time the stock price boomed and bring it up from 100 to 80th position in both indexes.

Now come the annual reconstitution time --- the Fundamental Index will look at CompanyX and say that based on these a,b,c,d weightings (economic footprint), CompanyX will be moved from its current position of 80 to position 95. So in other words, market speculators may have pushed the value of CompanyX based on price which drives its mkt-cap weighting way up to position 80 in the index. But the Fundamental index will eventually reweight the stock based on sales, dividends, book value, cash flow --- so if the company's value based on these fundamental weights does not reflect that super hike in it's stock price but just a milder growth in its business then during reconstitution, CompanyX will be reweighted to reflect that.

So that is the buy-low, sell-high capture action that the Fundamental indexes are doing. Which is why over the past 5 years - they have outperformed the standard and value indexes despite the fact that value underperformed.
Last edited by Kenster1 on Fri Jan 28, 2011 8:25 am, edited 3 times in total.
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Post by lazyday »

stlutz wrote:a) No stock will be more than .5% of the fund--I don't want my performance determined by 50 stocks. Equal-weighting these mega-cap companies doesn't really add much to costs since they are so liquid.
With too many rules, the remaining 200 largest companies may not be large enough to trade very cheaply.

Bridgeway already has a good equal weighted megacap index, but you would have to put up with about 3.5% in the largest holdings. It has about 35 or 36 companies, and doesn't trade furiously to stick perfectly to the index, even though the companies are truly megacap and therefore relatively cheap to trade. BRLIX, ER only .15%, not bad for a traditional mutual fund.

I will hold off from RAFI smallcap, EM, international, and especially intl smallcap until convinced that trading costs aren't eating into returns. The RAFI idea sounds nice if it were free, but I don't think it is free, there are extra trading costs compared to a steady market cap weighted index. Are benefits of RAFI worth the costs? For now, I doubt it. Maybe if a fund company with good execution experience and cross trading could keep costs down. I don't trust Powershares or Schwab.

We don't even know for sure if there are benefits of RAFI compared to tilting or decreasing % in bonds. But we do know that turnover isn't free.
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Re: Should price wag value or vice versa, RAFI strategies...

Post by Jacobkg »

grap0013 wrote:I was already sold on the RAFI strategy because it seems more contrarian than any other current available strategy available.
This statement is obviously false. There are an infinite number of strategies "more contrarian" than RAFI. How about 200% Lehman Brothers Holding Company (using leverage)? That would be pretty contrarian!

In all seriousness, I don't see how RAFI is contrarian at all. It's an attempt to pick stocks based on some measure of fundamental value. I think thats what most active funds seek to do. Indexing is more contrarian.

grap0013 wrote: Think about VBR for a minute. Since it's cap weighted it gives the highest weighting to the most expensive small cap value stocks. So basically it overweights the growthiest small cap value stocks.
This is also just false. Cap-weighting gives the highest weighting to the stocks with the highest market cap. This is completely independent of the book-to-market or other value metrics. The "growthiest" small cap value stock may or may not be the largest. It's true that VBR doesn't explicitly try to hold higher concentrations of more "valuey" stocks like RAFI might, but thats not what you said. Cap weighting holds the same percentage of every company in the index.
grap0013 wrote: Maybe it all comes down to your belief in efficient markets. Rafi believes in inefficient markets and cap weighting does.
This is probably the crux of your post. You don't believe in efficient markets and are thus choosing a strategy that deviates from the total market approach. That's fine, but I wouldn't call it "indexing". It's active management.
grap0013 wrote: If all markets were truly efficient wouldn't the stock market just go up by 0.04% per day to work out to be about 10% annualized?
Also false. New information about stocks is constantly emerging and the market reacts to it. According to efficient market theory, the market reacts immediately to incorporate all new information into the price. Since information is not doled out evenly on a daily basis, there is no reason to think prices would move like you suggest. Also, since the 10% return is by no means guaranteed (otherwise there would be no equity risk premium), there is no reason to believe stocks should rise .04% per day.
grap0013 wrote: Feel free to attack, comment, answer, any or all of the above. Or if the book changed your view on fundamental indexes.
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Post by Rodc »

FWIW: I own RAFI small international and emerging markets. They were the best I could get in my 401K where I do the vast majority of my investing. I don't think they are horrible (or I would have skipped them) nor do I think they are the greatest thing since sliced bread.

There are sound theoretical arguments for cap weighting. The argument is not that because the market says hold 10 times as much A as B, everyone should do that. Google "capital market line"

However, that theoretical argument is based on some fairly massive simplifications (assumptions, hypotheses) of reality, so I take it with a grain of salt. Also, in general these sorts of optimization problems that arise in math, science, engineering tend to have rather flat penalty functions, which is just a fancy way of saying any widely diversified low cost portfolio will do fine, especially if measured risk adjusted. Or, put even more simply, CAPM is not a horrible model and it says any widely diversified no-cost portfolio will have the same risk-adjusted return as any other. So RAFI should do fine before costs.

But, don't underestimate costs. There is the published ER, and then there is reality which includes trading costs. Trading costs for TSM are absolute rock bottom. The real benefit of TSM Cap Weighting in my mind is not the theory that says it is best, it is the fact that it is self-rebalancing, self-reconstituting. So, factor in trading costs. I have seen many estimates, but especially for smaller cap trading the costs can be non-trivial. Maybe 1% per 100% turn-over. Pick your favorite value, just remember it is not zero.

You should compare to a small value tilted portfolio using index funds. To a large extend, despite marketing strategy and hype, that is fundamentally (:)) what RAFI is doing with their sorts: value and size tilting. And a traditional slice and dice using cap weighted small and/or value is likely to have lower trading and lower overall costs. So, Slice/Dice is the natural benchmark.

Time will tell if RAFI has a magic formula or not. I would bet there is nothing magic, but over time the approach will more or less track other portfolios if you compare on a apple to apples Fama-French basis. Maybe a shade less unless they are very careful about costs.

But it might easily be decades before the picture starts to clear. Before that differences should be considered noise.
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Post by dharrythomas »

It's a valid strategy. It tilts away from the market in a value direction.

It will do worse than a value strategy when value is hot. It will do better than a pure value play when growth takes the lead. Like TSM, you own a slice of the whole market, it's just divided in a way that (gross oversimplification follows) sells high P/E stocks and buys low P/E stocks.

Looks to me like a mix of TSM and the Value indexes except that at higher investment levels you pay a slightly higher price for RAFI--but they do manage the mix for you.

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Post by camontgo »

Rodc wrote:Time will tell if RAFI has a magic formula or not. I would bet there is nothing magic, but over time the approach will more or less track other portfolios if you compare on a apple to apples Fama-French basis. Maybe a shade less unless they are very careful about costs.
I ran the FF3F regressions on PRF (ETF based on RAFI 1000) and tried to find the funds with the most similar FF3F loadings among more traditional "large value" ETFs. I used the 60 months from Jan 2006 to Dec 2010, which is all the data available for PRF.

PRF had a small and statistically insignificant positive alpha, and the most similar large value funds (IWD and IWW have very similar FF3F loading) had relatively large but still not quite statistically significant negative alphas.

It is interesting that nearly all of the performance difference occurs during the post-crisis recovery....maybe the fundamental weighting approach caused a more aggressive rebalancing into the most beaten down stocks?

I agree that more data is needed to make a stong case for or against fundamental indexing. Most of the difference so far occurs during the recovery from a single event.

Here is the plot:
Image

In case anyone is interested, I'm going to put all the regression details on my blog, but it might be a couple days before I get them written up: www.calculatinginvestor.com
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Post by Bongleur »

Is there a meta-list of funds & ETFs that are using the RAFI indexes? The M* search function sucks eggs...
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Post by caklim00 »

camontgo wrote: It is interesting that nearly all of the performance difference occurs during the post-crisis recovery....maybe the fundamental weighting approach caused a more aggressive rebalancing into the most beaten down stocks?
RAFI reconstitutes in March on a yearly basis. It reconstituted at the right time (March 2009) :D
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Post by boglety »

The list of funds are here

ETFs: Powershares (http://www.invescopowershares.com/products/)
Mutual Funds: Schwab (http://www.schwab.com/public/schwab/res ... ndex_funds)

Perhaps the discussion should be on which approach ETF or Mutual Fund to use for the international arena as the domestic tracking for both ETF or Mutual Fund is reasonable.

If only Vanguard was doing the ETF, the tracking error would be much limited and the theoretical benefits would become more obvious. Instead Powershares takes all of the security lending revenues and has high tracking error.....
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Post by camontgo »

caklim00 wrote:
camontgo wrote: It is interesting that nearly all of the performance difference occurs during the post-crisis recovery....maybe the fundamental weighting approach caused a more aggressive rebalancing into the most beaten down stocks?
RAFI reconstitutes in March on a yearly basis. It reconstituted at the right time (March 2009) :D
Thanks..that explains a lot. I looks like it was within just a couple of weeks of the optimal time.
Changes in constituent companies and weights for the Index will be implemented after the close of trading on the third Friday of March
So, a chunk of their outperformance definitely falls into the "luck" category.
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Post by Kenster1 »

The RAFI Five-Year Scorecard
By Rob Arnott | January 31, 2011

http://www.indexuniverse.com/sections/f ... ecard.html
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Post by grap0013 »

I only have access to mutual funds in my 403B brokerage account and on 10/04/2010 I got rid of my VISVX (ER 0.28 for SFSNX (ER 0.35). So I'm "gambling" with 7 basis points. Since then the RAFI fund is about 2% higher than the VG fund. May not sound like much, but the RAFI small is my sole U.S. equity holding so it's starting to equate to some pretty serious dough. You can call the RAFI strategy lucky or whatever, but its live performance has been great and most importantly, its making me money!
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Post by nisiprius »

grap0013, I perceive you as overenthusiastic and here's why.

1) Of course any investing strategy is going to sound good just after you've read a book advocating it. Then go read John C. Bogle's The Little Book of Common-Sense Investing and for a few days while the spell lasts you'll walk around convinced total market is the way to go.

2) This forum is not as closed-minded as you imply. In fact I think the prevailing thinking is "slice and dice." Cap-weighted within asset class but distinctly not cap-weighted across the nine Morningstar style categories.

3) Yes, I think the forum gets a little fetishistic about expense ratios. Personally, sure I'll click the link to convert to Admiral shares for free and not wait for it to happen automatically. But before that, no, I was not willing to convert to ETFs just to reduce an expense ratio from 0.2% to 0.1%.

But the reason why the forum is that way is that expense ratios are the only measurable thing that has a provable relation on performance. It's the only thing you can control that unquestionably affects results.

And when the ratios get up into 1% territory, they really matter, to the point of being detectable in the statistics for whole groups of funds.

I see that the (first thing Google found for me) expense ratio on PowerShares FTSE RAFI U. S. 1000 Portfolio, PRF, is 0.45%. A sane person could accept that, but seems high for an ETF--a plain old domestic large-cap stock ETF--doesn't it? It's at least something to think about.

Of course, all promoters of high-ER funds use what I call the salesperson's inverse: "Why would you care about costs if the fund can outperform your index fund after costs?" The answer is that I wouldn't if they did, but they don't. And the salesperson never says they actually do.

4) Any strategy that departs from cap weighting will sometimes do better and sometimes do worse. Obviously, nobody writes a book about it or starts a fund unless they think it will do better. Obviously, what you hear about is strongly biased in favor of a) stuff that's new, has a good story, and doesn't have a long enough track record to pass judgement on; b) stuff that happens to have done better, not worse.

In another thread, I amused myself by checking out what had happened to some much-ballyhooed "we're-better-than-plain-indexing" funds Fidelity introduced in 2007. Nobody got killed buying these instead of plain vanilla index funds, but mostly they did a skosh worse.

Oh, how long a "track record" do you need? Not ten years. Ten years is what "past performance does not guarantee future results" is all about. Ten-year winning streaks are common and mean nothing. If you were just looking at performance and knew nothing about the underlying assets, it would probably take at least thirty years to be sure that stocks outperform bonds. It probably takes fifty to be sure that small stocks outperform large stocks.

This leaves open a huge grey area for plausible ideas of which you can't say anything more than "who knows, there might be something in it, but you can't be sure."

Use the RAFI fund if you like, but understand why you shouldn't expect us all to share your enthusiasm. You've made a choice that's well within the range of the reasonable. Having made your choice, "stay the course" and stick with it. But don't try to convince me that it's the one best greatest optimum choice, and don't try to convince yourself that, either.
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