ETFs: cap-weight vs. fundamentals-weight

A criticism of the standard market capitalization-weighted exchange-traded fund, or ETF, is that it mimics an index that gives greater weight to stocks that are high in demand among investors, and are, therefore, overvalued compared to other stocks in the index. Conversely, stocks that are out of favor and become undervalued end up with smaller weightings in the index.

According to this criticism, then, the act of investing in a market cap-weighted ETF goes against sound investment principles. If you buy this argument, hope is not all lost. Some critics of the cap-weighted approach have come up with non-market capitalization-weighted indexes, which derive their individual security weights from company fundamentals.

They’re known as fundamentals-weighted indexes. And some fund companies, such as Invesco PowerShares Capital Management LLC, have created ETFs to track the performance of these indexes. One ETF we like among Invesco’s offerings is PowerShares FTSE RAFI US 1000 Portfolio ETF (NYSE–PRF).

This ETF tries to track the performance of the FTSE RAFI US 1000 Index, which, in turn, tracks the performance of the largest U.S. equities chosen on the basis of four fundamentals: book value, cash flow, sales and dividends. The 1,000 equities with the highest fundamental strength are weighted by their fundamental scores. The fund and the Index are reconstituted annually.

RAFI US outperforms over longer term

Since its inception in 2005, the FTSE RAFI US 1000 has outperformed its cap-weighted counterpart, the Russell 1000 Index. Since then, the RAFI US 1000 has returned a compound annual 9.1 per cent, while the Russell has returned 7.7 per cent.

Comparisons are mixed in more recent years. Over the past one- and five-year periods, the Russell has outperformed the RAFI. Over the past three years, however, the RAFI has done better than the Russell.

But we regard the longer-term results as more important, though past performance is no indication of what the future may bring.

The fund’s expense ratio of 0.41 per cent is higher than that of similar cap-weighted ETFs.

PowerShares FTSE RAFI US 1000 is a long-term buy if you want exposure to a fundamentals-weighted ETF and you can tolerate medium investment risk.


Canadian Mutual Fund Adviser, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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