Research Affiliates, the outfit that's behind the RAFI series of "fundamental" indexes put out a paper a few days ago entitled "Will the Real Passive Strategy Please Step Forward?" Typical of Rob Arnott, the piece's presumptive author, it's thoughtful and to the point.

And what was the point? Essentially that arguments questioning whether "fundamental" indexes are truly "indexes", um, miss the point. Arnott contends that, if anything, since the cap-weighted indexes reflect the collective biases of active managers, they're hardly the lilywhite exemplars of passive management that their advocates make them out to be. He cites the cap-weighted indexes' shifting sector weightings as evidence that they're far from immune to market sentiment. That is, they're passive in name only.

By contrast, Arnott argues that the RAFI weighting-scheme--which stresses "long-term secular" measures of value to approximate each firm's "economic scope" is less subject to the market's occassional flights of fancy. Oh, snap!

Our take? It's hard not to be struck by how elliptical this debate--which for some reason evokes the whole Slytherin/"mudblood" strand in Harry Potter--has become. The argument seems to revolve around form--i.e., attributes of an index...this is an index, no it's not, is, too!--rather than function. On the former count, I have no quarrel with Arnott's argument--the RAFI benchmarks are indexes by any reasonable definition of the term.

But does that mean the RAFI indexes are truly passive? Therein, to my mind, lies the substance of this argument. Yes, Arnott is correct that cap-weighting reflects the bets that the market--active managers and all--are placing. And, yes, I'd agree that these bets can push the market out of what you or I might consider equilibrium (provided we can agree on how to define equilibrium...for our money, it's the intrinsic worth of the businesses concerned, which doesn't seem all that far removed from what drives the RAFI indexes). But if we're trying to capture the market return...which, in my view, is the very epitome of a passive strategy...how can the index be anything other than cap-weighted? We can free-float adjust it 'til the cows come home, but cap-weighting remains the most faithful measure of the market, warts and all.

To which Arnott might reply: "All righty. Then the RAFI indexes are market indexes that aim to deliver more than the market on a risk-adjusted basis. Why should we resign ourselves to the market when a superior return is within our grasp?" Fine, but let's call a spade a spade--the RAFI indexes are, indeed, indexes. They're just not passive. They're making a bet. And that bet is that there are enduring measures of a business's true worth or, if you prefer, "economic scope". And by weighting firms on that basis and rebalancing at regular intervals, we can profit from the inevitable convergence of a stock's price to its true worth. It's a convergence bet. It's active management.

Is this Marty Whitman-style, benchmark-flouting contrarianism? No, of course not. It's rules-based security selection coupled with highly-mechanized portfolio management. Call it "quasi active" if you want. But it's still active. And that's where the 'will the real passive strategy please step forward?' posturing does investors a disservice--it conflates the "passive" and "indexing" questions into a kind of mush where investors can ostensibly have their cake (i.e., capture alpha) and eat it too (i.e., using 'passive' RAFI indexes). If we dropped 'passive' from the lexicon, then we'd at least be able to move onto the crux of the issue: Whether RAFI's quasi-active approach is worth its salt. Does it deliver excess returns (Arnott recently estimated that the RAFI indexes would add a normalized 2%-2.5% over the cap-weighted analogs)? What kind of factor bets, if any, does the strategy put on? And so forth.

Hermione might have been born to muggles. But she was one heckuva' talented witch. So, maybe it's time that RAFI embrace, not shy away from, its own "mudblood". It's ok to be quasi-active. Really.

Jeff Ptak

Morningstar, Inc.