From the October 2008 issue of Research Magazine • Subscribe!

Fundamentals Deliver Mixed Results

Is fundamental indexing a better way to invest?

A quick gander at the industry-sector exchange-traded funds following these alternative indexing strategies reveals a mixed bag in performance.

In mid-2008, each of the seven PowerShares Fundamental sector ETFs that track FTSE RAFI indexes were underperforming Select Sector SPDRs ETFs that follow the same industry sectors but with a traditional market capitalization weighting.

The Sector SPDRs track the nine industry sectors within the S&P 500. Over the past year, based on data through end-June, just one FTSE RAFI sector ETF (PRFS) has managed to beat its traditional index counterpart.

The PowerShares Dynamic sector ETFs showed slightly better performance, but mixed results.

On a year-to-date basis, the Dynamic sector funds were outperforming corresponding Sector SPDRs in seven of nine sectors. However, over the year ending in June, four of nine Dynamic sector funds underperformed vs. competing Sector SPDRs that follow these same industries but with a traditional indexing bias.

The Dynamic series selects stocks using non-disclosed quantitative filters and then weights companies with a modified equal weight. The Dynamic ETFs follow indexes constructed by the American Stock Exchange.

While the PowerShares Fundamental ETFs choose stocks with a passive bias, they weight companies based upon four fundamental measures: book value, cash flow, sales and dividends. The Fundamental series follows indexes built by FTSE and Research Affiliates.

The performance figures presented here are far from conclusive in determining the superiority of fundamental indexing. At best, during the short runs observed we can say that it's worked about half the time and in some cases doesn't seem to work at all.

The Sector SPDRs have annual expenses of just 0.23 percent versus the competing PowerShares ETFs, which charge a higher 0.60 percent. The large cost differential of 0.37 shouldn't be ignored.

Fundamental indexes attempt to outperform traditional indexes by selecting stocks according to a strict set of fundamental measures. Stocks with superior fundamentals are usually included, whereas those that fall short are eliminated. Some indexes may use multiple fundamental factors and others use just one determining factor like dividends.

WisdomTree offers sector ETFs with a fundamental focus (dividends), but their funds were excluded because they focus exclusively on international stocks.

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Ron DeLegge is the San Diego-based editor of www.etfguide.com.

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