Critics of market cap-weighted indexes argue they overweight overvalued stocks while underweighting undervalued ones. This leads to inferior performance, they say. And Powershares FTSE RAFI US 1000 Portfolio would seem to support their argument.
The standard exchange-traded fund, or ETF, typically attempts to mimic the performance of a capitalization-weighted index, such as the S&P/TSX Composite Index. But one of the criticisms levelled at such ETFs has to do with the indexes in which they invest.
With so-called cap-weighted indexes, stocks that gain popularity with investors will receive a larger share of the index as investors’ buying pushes their price and market cap up. In the process, such stocks can become overvalued.
On the other hand, stocks that lose favor with investors will receiver a smaller share of the index as investors’ selling drives their price and market cap down. In the process, these stocks can become undervalued.
Critics of ETFs that invest in cap-weighted indexes, therefore, argue that they force the investor who invests in them to overweight overvalued companies and underweight undervalued companies. Such an approach, they argue, runs contrary to sound investment principles.
Enter fundamentals-weighted indexing
The criticisms of standard index investing has given rise to non-market capitalization-weighted indexes that their creators feel more accurately measure the marketplace. Such indexes derive their individual security weights from company fundamentals, and are thus know as fundamentals-weighted indexes.
And certain investment companies have relied on these indexes to create exchange-traded funds that track their performance. Invesco Powershares Capital Management is one such company. Among its offering is POWERSHARES FTSE RAFI US PORTFOLIO 1000 ETF (NYSE-PRF), one of the offerings we recommend in our quarterly report “Best ETFs For You.”
This ETF seeks to track the performance of the FTSE RAFI US 1000 Index, which, in turn, tracks the performance of the largest US equities chosen on the basis of four fundamental measures: 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.
The Index has outperformed comparable market cap-weighted indexes over the past five years. Over this time frame, the FTSE RAFI US Index has a compound annual gain of 13.2 per cent, which compares favorably to the 10.5 per cent gain of the Russell 1000 Index and the 10.0 per cent gain of the S&P 500 Index.
As for the PowerShares FTSE RAFI US 1000 Portfolio, its return for the five years is 12.8 per cent. The difference between this return and that of the Index roughly equals the ETF’s management expense ratio of 0.39 per cent. In fact, the tracking error of the ETF is just 0.02 per cent, which is quite good.
Buy PowerShares FTSE RAFI US 1000 Portfolio for exposure to a fundamentals-weighted index ETF.
The ETF’s Top 10
Powershares FTSE RAFI US 1000 Portfolio attempts to track the performance of the FTSE RAFI US 1000 Index. Here are the ETF’s most recent top-10 holdings. Compare this list with the S&P 500 Index’s top holdings on page 143 of our September 10 issue.
|Bank of America||2.2%|
|JP Morgan Chase & Co.||1.7%|
|Wells Fargo & Co.||1.4%|