January 12, 2011

PowerShares, Research Affiliates Celebrate ETF's Many Happy Returns

Total returns show the Fundamental Index-based ETF beat cap-weighted indexes through the 5-year anniversary

Fundamental index giant Research Affiliates and Invesco PowerShares Capital Management LLC are celebrating the fifth anniversary of their fundamentally-weighted ETF with an announcement that their PowerShares FTSE RAFI US 1000 Portfolio (NYSE Arca: PRF), beat the Russell 1000 Index for the five years ended Dec. 31. PRF returned an annualized 4.05% for the five-year period, while the Russell 1000 Index returned an annualized 2.46%.

The PowerShares FTSE RAFI US 1000 Portfolio had a cumulative total return of 23.18%, “based on NAV,” outperforming the S&P 500 Index, with its cumulative total return of 11.99%; and the Russell 1000 Index, with its cumulative total return of 13.8% for the five-year period.

The difference between Research Affiliates Fundamental Index[es] (RAFI), and cap-weighted indexes, such as the S&P 500 Index or the Russell 1000 Index, is that a fundamental index like the RAFI uses the fundamental metrics of company performance—sales, dividends, cash flow and book value—to determine which companies to include, and their weightings in the index.

“The 1,000 equities with the highest fundamental strength are weighted by their fundamental scores," the announcement states. Cap-weighted indexes use the market caps of companies to determine their weightings, tilting the index toward those companies that have grown larger in market cap.

“To those who think that RAFI is just a value concept, it bears mention that value has generally underperformed growth during the past five years,” Research Affiliates, LLC chairman and founder, Rob Arnott (left), said in the announcement Monday. “The alpha generated by the Fundamental Index approach—roughly 2% per year in markets that were adverse to value strategies—offers further evidence that this is far more than a simple value tilt. Rather, the main source of added value comes from contra-trading against the fads, bubbles, crashes and shifting expectations in the market—selling the most popular and trendy stocks while buying the feared and loathed companies.”

Rob Arnott answered three questions from AdvisorOne.com in an exclusive e-mail:

1)  What’s the most important takeaway for advisors about this five-year milestone for this ETF?

Arnott: The past five years ratifies the importance and the efficacy of the Fundamental Index concept.  During a five-year span in which value has underperformed growth—an environment in which the critics would have predicted RAFI underperformance—PRF beat the cap-weighted ETFs by over 200 bps per annum, net of all fees and implementation costs. 

More important, PowerShares entire roster of eight Fundamental Index ETFs for stocks around the world has hit the cover off the ball, albeit over shorter three- to four-year spans: U.S. large and small (PRF and PRFZ), Emerging Markets (PXH), Europe (PEF), Japan (PJO), Asia ex-Japan (PAF) and international small (PDN) have all beat the relevant competing cap-weighted ETFs. The sole exception, Developed ex-U.S., lost nine [basis points] bps relative to GWL [SPDR S&P World ex-U.S.], in the face of over 200 bps per year underperformance by value indexes relative to growth indexes! Averaging across all eight, we find over 200 bps of average outperformance, despite higher fees and higher turnover, and despite the fact that value lagged growth in most of these markets.

2)  Are there any types of markets where the Fundamental Index would likely underperform the cap-weighted index?

ArnottIn a growth-dominated market, in which value is being savaged, RAFI strategies should underperform. The surprising thing is that this underperformance has tended to be modest, while outperformance during surges for value stocks tends to be impressive.

3)  What’s next for Research Affiliates?

ArnottThis idea is proliferating all over the world. Bond applications are only just starting. With cap-weight in stocks, we concentrate our investments on the highest-multiple growth stocks, the popular favorites, the stocks with great momentum. Why, exactly, should we expect to get a big “risk premium” investing in the stocks that are popular and beloved, with lofty growth expectations already baked into the price?

The logic is even more compelling for bonds. With a cap-weighted bond index, we invest more in the companies or countries with the loftiest debt burdens. Australia has three times the GDP of Greece; Greece has three times the debt of Australia. Why should we invest three times as much in Greek debt as Aussie debt? Wouldn’t the opposite make more sense?  I think the rationale for Fundamental Index in bonds is so very compelling that its growth will eventually dwarf the growth of RAFI in stocks.

We’re also having a lot of fun exploring the implications of Fundamental Index for finance theory, notably the Efficient Market Hypothesis and CAPM [capital asset pricing model]. The challenges that RAFI poses to neoclassical finance are important, perhaps even profound."

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PowerShares has six fundamental index equity ETFs and a high-yield corporate bond ETF that all use the Research Affiliates Fundamental Index methodology. The PRF ETF has a gross expense ratio of 45 basis points, but it is capped at 39 basis points until “at least,” Aug. 31, 2011.

“We are very pleased to celebrate this five-year milestone for the PowerShares FTSE RAFI US 1000 Portfolio, which has delivered on its goal of providing investors improved risk-adjusted returns compared to cap-weighted benchmarks,” Ben Fulton, Invesco PowerShares managing director of global ETFs, stated in the release. “Invesco PowerShares currently offers six equity ETFs based on the FTSE RAFI Fundamental Index methodology and each one is ranked in the top third of their Lipper categories. We believe the PowerShares ETFs based on this methodology represent an important alternative to cap-weighted portfolios.” 

For more on fundamental indexes on AdvisorOne.com, please see:

Rob Arnott on Seeking a Better Way to Invest in Bonds: The Weekend Interview

Research Affiliates, ProShares Launch Long/Short ETF

ProShares Launches Two Volatility ETFs

Super Bowl of Indexing Conferees Debate Strategy Indexes

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