RAFI ETFdb Portfolio

Published on by on September 23, 2010 | Updated February 11, 2014

Portfolio Strategy

Intermediate Risk ToleranceThe RAFI ETFdb Portfolio is designed for investors looking to construct a well balanced and cost efficient equity portfolio, but who are interesting in avoiding traditional weighting methodologies that determine individual security allocations based on market capitalization.

Many of the indexes underlying the most popular equity ETFs are cap-weighted; the component stocks and weighting afforded to each are determined based on the company’s market capitalization (which is equal to share price multiplied by shares outstanding). While this methodology for index construction is popular, many have voiced concerns over the concept of constructing investable assets (i.e., ETFs) that determine holdings in the same way.

RAFI 101

The primary criticism of market capitalization weighted indexes is this: because there is a direct relationship between stock price and the weighting assigned, there is the potential to overweight overvalued stocks and underweight undervalued stocks. The RAFI concept was devised by Research Affiliates, a firm founded by Rob Arnott. This methodology uses multiple fundamental measures of size to determine weighting structures. Instead of determining component stocks and individual allocations based on market cap, the FTSE RAFI Index series is designed to “reflect each company’s current economic footprint” by analyzing five-year average sales, five-year average cash flow, book value, and five-year average dividends. “The point of fundamental indexing isn’t to cherry-pick specific measures that have historically worked well,” says Arnott. “It’s to build a portfolio that broadly represents the overall economy.”

In terms of individual stocks, this ETFdb Portfolio will maintain significant overlap with portfolios constructed using cap-weighted indexes. The primary difference–the weighting methodology–may seem minor, but it can have a very real impact on bottom line return. For investors who buy in to the RAFI methodology, this ETFdb Portfolio provides an outline for constructing a balanced portfolio that will avoid the potential pitfalls of cap weighting.

It should be noted that this ETFdb Portfolio consists entirely of equities; no fixed income, real estate, or currency ETFs are included. As such, investors interested in the investment thesis behind this ETFdb Portfolio but unwilling to maintain 100% equity exposure may wish to combine the components profiled herein with a mix of fixed income funds.

Because this ETFdb Portfolio consists entirely of equity securities, it is designed to be used in conjunction with other asset classes, potentially including fixed income and commodities. The ratings below reflect the characteristics of this ETFdb Portfolio relative to other all-equity portfolios.

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