Are You A “Ben Graham Defensive Investor”? by Charles Aram, Research Affiliates

Get The Full Warren Buffett Series in PDF

Get the entire 10-part series on Warren Buffett in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues


  • Research shows that the human condition can be the defensive investor’s worst enemy.
  • Graham admonished investors not to sell securities, especially on the downside, if their fundamentals remain sound.
  • A “Ben Graham defensive investor” should find much to like in the RAFI™ Fundamental Index™.

Are you a value investor? Not everyone is. But if you are, that is, you believe in buying companies with good fundamentals at cheap prices and selling companies (promising or not) that have ridden momentum to the point of overvaluation, you are following in the footsteps of one of the most insightful and forward-thinking investors of all time, the “father of modern security analysis,” Benjamin Graham—and by extension, those of Warren Buffett, who claimed of Graham that “[m]ore than any other man except my father, he influenced by life” (Graham, 2006, p. ix). No light testament.

One might think that Graham’s outspoken preference for value investing would pit him against the early proponents of index investing; it turns out, however, that his pragmatic perspective on investing did exactly the opposite. Although Graham did not live to see the explosion of index funds that originated with John Bogle at Vanguard in 1975, indications are that he would have found much about them to like, as Jason Zwieg (2015) pointed out in his article “Would Benjamin Graham Have Hated Index Funds?” In a June 1974 speech, Graham explained:

More and more institutions are likely to realize that they cannot expect better than market-average results from their equity portfolios unless they have the advantage of better-than-average financial and security analysis. Logically this should move some of the institutions toward accepting the S&P 500 results as the norm for expectable performance. In turn this might lead to using the S&P 500…as [an] actual portfolio….

Graham expounded further on the subject in a brokerage firm’s client Q&A in the fall of 1976, stating that the average institutional client should be content with the DJIA results, or the equivalent, and that “they should require approximately such results over, say, a moving five-year average period as a condition for paying standard management fees to advisers and the like” (Zwieg, 2015).

So not only did Graham subscribe to the idea that an index fund’s market return should be viewed as acceptable for the average investor, but that in order to earn their standard fees, active managers have a duty to match or improve on the market return over relatively long (at least by today’s standards) investment horizons. Few managers are able to achieve this. Figure 1 shows that from 2005 to 2014, of the 1,147 surviving U.S. large-cap mutual funds, only 10% outpaced the market by 1% or more, after fees. Almost four times as many lagged the market by 1% or more. It’s a safe bet that the funds that failed would not improve this bleak picture.

Ben Graham

Given that a market-cap-weighted index fund offered investors a low-cost, market-return alternative to active equity management beginning in the mid-1970s, investors received yet another game-changing boost, roughly 30 years later, with the introduction of the RAFI Fundamental Index.

The RAFI Fundamental Index severs the link between stock price and portfolio weight, weighting index constituents by sales, cash flow, dividends, and book value (i.e., a company’s metrics of fundamental value). Such a structure retains the positive attributes of passive investing—low turnover and low trading costs, high capacity, and broad economic representation—while delivering excess returns versus a core cap-weighted market portfolio. As of July 31, 2015, the broadest FTSE RAFI indices have exceeded the performance of corresponding cap-weighted indices since their November 2005 inception, even though value indices have been savaged. The Developed Ex US 1000 Index posted a 10-year annualised return of 5.96% compared to the 5.50% return of MSCI EAFE Index, and the FTSE RAFI 1000 Index posted a 10-year annualised return of 9.04% compared to the S&P 500 Index return over the same period of 7.89%.

In his ground-breaking guide to investing, The Intelligent Investor, Graham makes a crucial distinction between a “defensive” investor and an “enterprising” investor. The defensive investor’s chief emphasis is on “the avoidance of serious mistakes or losses” with a secondary aim of “freedom from effort, annoyance, and the need for making frequent decisions.” These are common goals for passive investors and for patient value investors. In contrast, the enterprising (or active) investor is devoted to finding securities that are “both sound and more attractive than the average” and, over time, should be rewarded by earning a higher average return than the defensive, or passive investor. That said, Graham expressed “some doubt” this would always be the case, given the vagaries of market conditions (Graham, 2006, p. 6). Ample evidence suggests that most active investors can’t help themselves: they chase the popular and expensive issues, proving Graham’s doubts true over the long term.

Graham consistently stressed the importance of value investing with a focus on security selection supported by a firm’s financial strength, earnings, dividends, and assets. Preferring the objective to the subjective, he provided a set of rules for security selection decisions as a means to remove subjective factors that can mislead investors. Errors of judgment that can occur during the market’s heights of euphoria and troughs of despair, often a function of decision inputs unrelated to intrinsic value, are anathema to well-reasoned, thorough analysis that occurred prior to the market’s gyrations.

Investors who identify as a “Ben Graham defensive investor” and adhere to his belief in the long-term benefits of value investing will find much to like in the Fundamental Index strategy. The strategy applies a disciplined, quantitative approach to security selection, annually reweighting portfolio positions to align with each company’s fundamental value metrics. The effective result is to sell securities whose price, and therefore capitalisation, has increased over the year relative to its metrics, and to buy those securities that have had the opposite experience.

The reweighting mechanism of the RAFI Fundamental Index is not based on value per se, but the systematic rebalancing that contra-trades as price changes stray from (grow or shrink faster than) company fundamentals. The result is a dynamic exposure to value and size factors, ramping up exposure to these factors when they are most out of favour and lowering exposure in whatever the market favours most. Figure 2 compares the excess returns earned by the RAFI strategies over the last decade with the value premiums earned (or not) for the same strategies. The value premium lagged across most markets, while the RAFI strategies outperformed in each. Looking back 50 years, the respective Sharpe ratios of the cap-weighted portfolio and the fundamentals-weighted portfolio are 0.33 and 0.47,1 respectively, indicative of their relative performances.

Ben Graham

If we accept Graham’s thesis that a value investing strategy will consistently deliver a premium over a market portfolio, which is a cap-weighted portfolio, and empirical research has documented the existence of a value premium over the last 86 years, albeit with the exception of the last decade,2 the obvious question is: Who are the investors willing to take the other side of the trade? After all, the net performance of all market participants—relative to the

1, 2  - View Full Page