Does Your Portfolio Need A “RAFI ETF”?

by on March 3, 2010 | Updated November 6, 2012 | ETFs Mentioned:

In recent years, investors have begun moving away from traditional active management in favor of more cost-efficient indexing strategies. The result has been a tremendous surge in the popularity of ETFs and a serious threat to actively-managed mutual funds that have dominated the investment industry for decades. As market indexes have transitioned from performance benchmarks to investable baskets of securities, the underlying methodologies have, not surprisingly, been the subject of increased analysis and scrutiny. As many investors now know, the system used to select and weight individual components can have a major impact on bottom line returns. And there are a number of ETF issuers out there who think they’ve come up with superior alternatives to the methodologies used by the vast majority of investors [see 1,400+ ETFdb Realtime Ratings].

The Problem(s) With Cap Weighting

Market cap-weighted indexes generally determine both component companies and the weight given to each based on the market capitalization (i.e., share price times shares outstanding), meaning that the largest companies receive the largest weighting. The result is often top-heavy benchmarks: the top ten holdings of the S&P 500 SPDR (SPY), for example, account for nearly 20% of total assets.

A potential side effect of the cap-weighted methodology is the reversal of the “buy low, sell high” philosophy many investors strive to follow. Cap-weighted benchmarks are inherently inclined to overweight overvalued stocks and underweight undervalued stocks. As such, cap-weighted indexes also have a tendency to participate in speculation, inflating (and bursting) in lock step with market bubbles. These potential drawbacks aren’t merely hypothetical. During the tech bubble of the early 2000s, companies like Cisco and Qualcomm traded at price-to-earnings multiples of 100 times, and the tech sector swelled to account for 30% of the S&P 500. When the bubble burst, cap-weighted indexes that had huge exposure to technology stocks were devastated [For ETF industry news, sign up for the Free ETFdb Newsletter].

The first generation of equity ETFs consisted primarily of funds linked to market cap-weighted benchmarks, such as the S&P 500, Russell 1000, MSCI Emerging Markets Index, and MSCI EAFE Index. Despite the potential drawbacks, the vast majority of assets in equity ETFs can still be found in cap-weighted products today, a testament to investors’ bias towards established and familiar methodologies. But the last few years have seen the introduction of a number of alternative weighting methodologies. WisdomTree is perhaps best known for its line of earnings-weighted and dividend-weighted ETFs. RevenueShares offers four ETFs that determine allocations to individual stocks based on top line revenue. Rydex pioneered the area of equal weighting, a concept ALPS tweaked for EQL (it should be noted that State Street offers a number of ETFs linked to equal-weighted benchmarks as well).

FTSE RAFI Methodology

Another alternative is the one developed by Research Affiliates that uses multiple fundamental measures of size to determine weighting structures. Instead of determining component stocks and individual allocations based on market cap, the FTSE RAFI Index series is designed to “reflect each company’s current economic footprint” by analyzing five-year average sales, five-year average cash flow, book value, and five-year average dividends. “The point of fundamental indexing isn’t to cherry-pick specific measures that have historically worked well,” says Rob Arnott, chairman of Research Affiliates. “It’s to build a portfolio that broadly represents the overall economy.”

The potential advantages of such a methodology are relatively simple: because the ranking and weighting system breaks the link between stock price and portfolio weight, a fundamental index won’t be influenced by irrational market factors that cause prices to deviate from their intrinsic value. Moreover, the use of four separate measures of firm size (three of which use five year averages) tempers the extent to which an outlying data point can impact the ultimate weighting given to a stock.

FTSE RAFI ETFs

Cap-Weighted Index Fundamental Strategy Index Ticker
Russell 1000 Index FTSE RAFI 1000 PRF
MSCI EAFE Index FTSE RAFI Developed Markets ex-U.S. PXF
MSCI AC Asia Pacific ex-Japan FTSE RAFI Asia Pacific ex-Japan PAF
MSCI Japan FTSE RAFI Japan PJO
MSCI Emerging Markets FTSE RAFI Emerging Markets PXH
MSCI Europe FTSE RAFI Europe PEF
MSCI EAFE Small Cap FTSE RAFI Developed ex-U.S. Small-Mid PDN
Russell 2000 FTSE RAFI U.S. 1500 Small-Mid PRFZ

PowerShares has partnered with Research Affiliates to develop a line of ETF products linked to Fundamental Indexes, including both domestic and international equity products. The absolute returns delivered by many of the FTSE RAFI ETF since inception aren’t necessarily impressive (most were introduced in 2007 before markets crashed), but the performance relative to traditional cap-weighted products is noteworthy in many cases.

The FTSE RAFI 1000 Portfolio (PRF) has outperformed the iShares Russell 1000 Index Fund (IWB) by about 650 basis points since its launch in late 2005. The FTSE RAFI Emerging Markets Portfolio (PXH) has outpaced the iShares MSCI Emerging Markets Index Fund (EEM) by about 300 basis points since its inception in 2007.

In the world of investing, an abundance of choices is a very good thing. ETFs covering nearly every sector of the U.S. market and every corner of the globe have provided an abundance of options, and now the development of various weighting methodologies has further enhanced the ability to target and refine risk and return requirements.

For more looks “under the hood” of popular ETFs, sign up for our free ETF newsletter. For a closer look at the Fundamental Index ETFs, see this guide from PowerShares (PDF).

Disclosure: No positions at time of writing.