The above is hardly a new discovery Eugene Fama has written about the size and value premium (using only book value) for decades and built the indexing firm Dimensional Financial Advisors (DFA) on index products using this methodology. Arnott just seems to have refined the technique by adding other factors.
The reasoning is well known: cap weighted indexes become concentrated in a small number of stocks with large market cap and usually high p/e values. In other words they are skewed to large growth stocks and in periods of high flying markets like the late 1990s are particularly prone to "bibble risk" In other words over the long run value beats growth (as both indexers and many many active managers have both found As the article explains: The explanation in my view and that of many others far brighter than me is behavioral: investors become enamored of glamour stocks and pay too much for them:
But as far as a revolutionary discovery in market behavior ...I'm with the view expressed here:
And in fact as others have noted the correlation between arnotts large cap and small cap indexes is extremely high (see below for the russell indices it is close if not equal to 1.0 = 100% correleation) with the corresponding indexes from russell as well as with the the index funds from DFA. However correlation is not the whole story 3 funds can have high correlation but far different returns and on this count the Rafi index performances are quite impressive. Below are PRF (large cap) and PRZ(small cap) compared to the corresponding etfs representing indices from S+P (spdrs), Russell (ishares) and MSCI (vanguard), The outperformance is impressive and consistent enough for me to make these two my choice for the large value and small value allocation in my portfolios.
Three Year tables of total return:
|Correlation PRF and IWD Russell Large Value 3yrs of 60 day correlation|