From the November 2013 issue of Research Magazine • Subscribe!

Are Fundamental ETFs Better?

While traditional market capitalization weighted funds still rule the roost, ETFs that use alternative weighting strategies deserve attention.

At the end of summer, there was nearly $1.5 trillion in assets under management across the U.S. universe of exchange-traded products, including ETFs and ETNs. And while traditional market capitalization weighted funds still rule the roost, ETFs that use alternative weighting strategies deserve attention.

Through mid-2013, non-market cap weighted funds captured 42% of equity ETP flows YTD, more than two times their share of equity assets compared to 2012, according to BlackRock. Key drivers to this trend are dividend income and minimum volatility funds.

It should be noted the universe of non-market cap weighted ETFs includes equal weight funds, low and high volatility products along with fundamentally weighted products that use one or multiple factors for screening and weighting securities. To be sure, investors, professional and retail, have already displayed plenty of adulation for equal weight ETFs.

For example, the Guggenheim S&P 500 Equal Weight ETF (RSP) has outperformed the SPDR S&P 500 (SPY) and related S&P 500 tracking funds by significant margins for some time. Over the past 10 years, RSP has delivered a 9.74% return compared to 7.47% for SPY.

Then there are the examples of equal weight technology sectors that have outperformed cap weighted peers that featured outsized exposure to Apple. Over the past year, Apple is down over 27%, so it might be a pleasant surprise that the cap-weighted PowerShares QQQ (QQQ) is up 16.67%. However, the real pleasant surprise is how the First Trust NASDAQ-100 Equal Weighted Index (QQEW) is up nearly 31% over that same time. This highlights the advantages of devoting less concentration to stock market giants, especially when they falter.

Fundamental Factors

Various ETF issuers feature fundamentally weighted funds that use one or more factors for selecting and weighting stocks.

For example, the RevenueShares ETFs own the same stocks within the S&P 500, S&P MidCap 400 and S&P SmallCap 600, but weight holdings according to top line revenue. “We believe that by applying the revenue weighted methodology to the S&P indexes, investors will lower their exposure from overvalued companies that are inflated by the market,” states the company’s website.

Other providers, like InvescoPowerShares, take a multi-factor approach, weighting stocks by book value, cash flow, dividends and sales.

Importantly, advisors should note that each issuer applies different fundamental methodologies to their respective ETF menus. Some fundamental ETFs have shown a propensity for outperforming their cap weighted rivals.

Case Study

InvescoPowerShares has one of the largest stables of fundamentally weighted ETFs, and the underlying indexes are managed by FTSE and Research Affiliates (RAFI).

“Unlike traditional benchmark indexes, the FTSE RAFI Index series uses a weighting structure that embodies four fundamental measures of size: five-year averages of sales, cash flow and dividends plus current book value,” according to a PowerShares white paper.

We chose to examine one of the largest PowerShares/RAFI ETFs, the PowerShares FTSE RAFI US 1000 Portfolio (PRF). PRF has $2.35 billion in assets under management, has average daily dollar volume of over $8 million and almost never trades at a noticeable premium or discount to its net asset value, indicating the fund is sufficiently liquid.

PRF competes directly with the $7.97 billion iShares Russell 1000 ETF (IWB). Both funds feature ExxonMobil as one of their top holdings, but Apple is not even a member of PRF’s top 10 lineup. There are noticeable differences at the sector level as well. IWB has an 18.48% weight to financials and a 9.77% allocation to energy stocks. Those sectors account for 21% and 11.9% respectively, of PRF’s weight. IWB is the less expensive with annual fees of 0.15% compared to 0.39% for PRF.

Low expense ratios are often a source of allure for ETF investors, and if all things were equal, then IWB would be the easy choice. Everything is not equal in this comparison, particularly when it comes to how PRF’s use of book value, cash flow, sales and dividends as screening factors has led to noticeable, long-term performance differentials.

An investor that had put $100,000 into IWB five years ago would have roughly $140,000 today. Not too shabby, but the investor that opted for PRF would have over $160,000 today, enough of a gap to render the expense ratio difference a moot point. For those with a preference for narrower time frames, PRF has easily topped IWB over the past 12, six and three months while being only slightly more volatile.

Embracing Fundamentals

Fundamental indexing is gaining a more prominent place in ETF menus.

In August, Charles Schwab unveiled six new Schwab Fundamental Index ETFs that charge annual expense ratios between 0.32% to 0.46%. The new ETFs are linked to the Russell Fundamental Index Series, which is based on methodology developed by Rob Arnott and Research Affiliates.

“We’re here to help advisors and investors alike recognize that Fundamental Index funds—whether ETFs or mutual funds—are a thoughtful way to gain broad industry exposure, right alongside their market cap-weighted counterparts,” said Marie Chandoha, president of Charles Schwab Investment Management. “We believe the systematic approach inherent in fundamentally weighted methodologies, when used alongside cap weighted strategies, enables investors to diversify and balance their exposure.”

Conclusion

The PRF/IWB comparison is just one example of differences that fundamental versus market cap weighting can make. It should be noted that not all fundamentally weighted ETFs outperform their cap weighted rivals. Still, there are notable examples of outperformance by fundamental ETFs. The PowerShares FTSE RAFI US 1500 Small-Mid Portfolio (PRFZ) has beaten the iShares Russell 2000 ETF (IWM) by more than 400 basis points over the past year.

According to the Independent Advisor Outlook Study by Schwab Advisor Services, 59% of its RIA clients currently invest in fundamentally weighted products, and roughly one in five plans to invest more in the near term.

It would be erroneous to see fundamental weighting as the “holy grail” of ETF construction. However, it is evident that some fundamental ETFs have a worthy place in client portfolios over cap weighted products. 

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