ETFs: A Return to Fundamentals
A suite of Exchange-Traded Funds based on fundamental-weighted indexes has outperformed the competition since its inception.

Written by Marsha Zapson

Over the last century, broad-market financial indexes have taken different approaches addressing two important index considerations. First, how can an index truly represent a marketplace, and second, how much weight should constituents be given and how should those weights be determined?

Prevailing index methodology has evolved in pursuit of reflecting a company’s true size. The Dow Jones Industrial Average, launched in 1896, simply weighted its initial 11 stocks by their price. When the Standard & Poor’s 500 Index came along in 1923, it used market capitalization. More recently, indexes have used a float-adjusted version of marketcap weighting. Each new method offers an enhancement of the previous method but maintains one common determinant: market price.

According to FTSE RAFI, a major index provider, fundamental indexing utilizes objective criteria by which a company’s size can be determined and used for weighting. Such a methodology can prevent indexes from becoming top heavy with companies whose prices have been inflated due to earnings projections, corporate news, market sentiment or speculation.

The indexes underlying the PowerShares FTSE RAFI use four fundamental measures to weight constituents: sales, cash flow, book value and dividends.

An Innovative Approach

In contrast to cap-weighted indexes, which weight companies by a value assigned by the stock market, fundamental indexes weight companies by measures generally not influenced by market price. FTSE RAFI believes that cap-weighted indexes can fail to correctly represent a company’s underlying economic size and strength, ultimately leading an index to overweight overvalued stocks and underweight undervalued stocks. Such flaws are inherent in cap-weighted indexes while they are mitigated in fundamental weighted indexes.

The indexes underlying the Power- Shares FTSE RAFI index—a suite of eight fundamental ETFs providing broad exposure to U.S., country-specific and ex-U.S. regional markets—use four fundamental measures to weight constituents: sales, cash flow, book value and dividends. Additionally, FTSE RAFI uses a five-year average of each fundamental measure. Averaging data over several years stabilizes constituent weightings, which reduces turnover and ultimately decreases trading costs.

Construction of a FTSE RAFI index begins with an evaluation (based on those four fundamental factors) of over 2,500 U.S.-listed and over 2,000 globally listed equities. The financial size of each company is determined and given a corresponding weight within the index (relative to its peers).

To be clear, it is the market that ultimately determines a company’s value and FTSE RAFI indexes are not intended to minimize or usurp that role. Rather, by removing price from the equation, the FTSE RAFI indexes provide a more sensible way of weighting companies within an index. The market still determines a company’s value, but its financial size determines its weight in the index.

“The FTSE RAFI methodology reduces the impact of emotion within the index, making it a more objective representation of the market,” says Bruce Bond, president and CEO of Invesco PowerShares. “As a result, component stocks avoid being under- or overweighted based solely on their market cap and have a better chance of receiving a weighting reflecting their true economic footprint relative to their peers.”

PowerShares’ FTSE RAFI US 1000 Portfolio (PRF), which is designed to track the performance of the 1,000 largest U.S. equities, stands as a proxy for the U.S. market. From PRF’s December 2005 inception through August 31, 2009, it was down 0.70% annually. In comparison, the SPDR S&P 500 ETF (SPY) was down 3.5% for the same period.

Just prior to PRF’s most recent annual reconstitution and rebalance in March 2009, the stock market hit a 13-year low. But stock prices had deteriorated much more than the average fundamentals of the underlying companies, particularly in financials. As a result of PRF’s March rebalance, exposure to financial stocks in the fund increased from 15% to 24%. By comparison, the declining price of financials had pushed the sector’s weight in the S&P 500 down to 10% by the end of February 2009.

“The FTSE RA FI methodology reduces the impact of emotion
within the index, making it a more objective representation of the market.”

Bruce Bond

President and CEO of Invesco PowerShares

True Value

As the S&P 500’s weight in financials declined in 2008, the index got the boost it needed to outpace the FTSE RAFI US 1000 Index (PRF was down 40.1% while SPY was down 37% for the year). But in 2009, as financials rallied, PRF bested SPY. Year to date through August 31, 2009, PRF was up 34.6%, while SPY was up 15.0%. The differences in the indexes’ respective weighting methods were highlighted in much the same way during the tech bubble of 1999 and 2000, when dot com stocks had oversized market caps but no true financial size.

PRF is not the only FTSE RAFI ETF that has outperformed its competitors since its inception. In fact, the entire suite of FTSE RAFI ETFs has beaten cap-weighted ETFs offering exposure to similar market segments. “While the goal was not outperformance,” says Bond, “outperformance has nevertheless been a natural result of fundamental indexing, which tries to more accurately reflect the true financial size of companies in the publicly traded economy.”

 

Investing in ETFs and other exchange-traded products involves risks similar to those with any exchange-listed investment, including possible losses. Shares are not FDIC insured, may lose value and have no bank guarantee. Before investing in ETFs and ETNs, investors should carefully review available documents, including risk disclosures and other disclaimers included in the products’ prospectuses, and assess their suitability for their own financial circumstances.