Those of us convinced of the superiority of an investment strategy using fundamental index (RAFI) funds over traditional cap-weight funds need to avoid the error of merely assuming that all is well and merely look for positive evidence that it works. We need to be on guard for things that might go wrong. My little one-vs-the-other tracking table at the bottom of this blog recently turned from net fundamental advantage red to cap-weight green and it is almost all due to the effect of the Canadian equity component of the portfolio where the cap-weight iShares TSX 60 (XIU) stands against its RAFI competitor Claymore's Canadian Fundamental Index ETF (CRQ). Why, I asked myself?
Potash Corp Takeover Bid
The buyout battle initiated by BHP Billiton for Potash Corp of Saskatchewan (POT) on August 17th caused a typical leap in the share price of POT (see Google Finance chart below). Guess which fund, XIU or CRQ, did better. Yup, XIU did, because of its much greater holding of POT before the formal takeover bid.
Note how the orange line of XIU jumps above the blue of CRQ the day of the bid. POT's weight in XIU has bounced up and down in the past year but the iShares document store shows weights varying around 3.5% through the past year while the fundamental weight has been much lower. On August 19th, after the takeover announcement CRQ still had only a 1.8% weighting in POT, up from 1.4% at the end of March, while POT jumped to 4.6% of XIU.
The media rumour about a possible takeover has apparently been around a long time, judging by this March 2009 article in the Telegraph and this Andrew Willis article in GlobeInvestor from last October, which may account at least in part for the fact that POT has occupied for over a year in XIU a weight far above what is justified by its profitability and other accounting valuation data, which is what CRQ reflects. (Though one wonders what those smart professional investors were doing bailing out of POT just before the takeover bid - note the big price dip through from March to early July this year.)
The moral of the story is that RAFI will underweight stocks subject to takeover speculation and in a restricted market like Canada's where a fairly small number of stocks occupy much of the index, any takeover will have a much more pronounced effect.
However, not all takeover speculation comes to action and not all takeover bids succeed and this one isn't a fait accompli either. (Hmm, slip of the tongue there folks, didn't mean to say that passive index investing involved being part of the market's indulgence in a stock speculation ... or did I? ;-) Maybe POT's price will fall back down. It remains to be seen whether such takeovers are a factor significant enough to invalidate the RAFI strategy but for now, I'm holding steady.