RAFI ETF Turns Five, Celebrates Results

by on January 12, 2011 | ETFs Mentioned:

The PowerShares FTSE RAFI U.S. 1000 Portfolio (PRF) recently passed its five year milestone, a period during which the fundamentally-weighted product outperformed many more popular market-cap weighted ETFs. PRF debuted in December 2005, and for the five year period ended December 31, 2010 it achieved a cumulative total return of 23.1% (based on NAV). That compared quite favorably to the more widely replicated Russell 1000 Index, which added about 12% during the same period.

RAFI weighting has emerged as one of the more popular alternatives to market capitalization weighting in recent years, as the ETF boom has brought increased scrutiny to the manner in which indexes are constructed and maintained. Because weightings assigned in market cap indexes are linked directly to the stock price of underlying securities, there is a tendency to underweight undervalued securities and overweight overvalued stocks. The RAFI methodology breaks the link between stock price and index weight, using four fundamental measures of company size: book value, cash flow, sales, and dividends. PRF consists of the 1,000 largest U.S. equities based on “fundamental score,” not market capitalization. That can lead to big differences in weightings vis-a-vis cap-weighted benchmarks. Apple, for example, is the second largest component of the Russell 1000 Index Fund (IWB) at about 2.4% of assets. But the company makes up less than 0.6% of PRF, due partially to the lack of historical dividend payments from the tech giant.

While there is considerable overlap among the holdings of IWB and PRF, the differences in weightings have resulted in very different return profiles [see For ETF Investors, The Details Matter]. “We are very pleased to celebrate this five-year milestone for the PowerShares FTSE RAFI US 1000 Portfolio, which has delivered on its goal of providing investors improved risk-adjusted returns compared to cap-weighted benchmarks,” said Ben Fulton, Invesco PowerShares managing director of global ETFs. “Invesco PowerShares currently offers six equity ETFs based on the FTSE RAFI Fundamental Index methodology and each one is ranked in the top third of their Lipper categories.”

Top Five Holdings
PRF IWB
Exxon Mobil (3.10%) Exxon Mobil (2.90%)
General Electric (2.34%) Apple (2.36%)
AT&T (2.12%) Microsoft (1.64%)
Chevron (1.92%) General Electric (1.5%)
Bank Of America (1.79%) IBM (1.43%)

Booms, Busts Generate Alpha

A look back at the recent financial crisis may help to understand the potential advantages of the RAFI methodology. When financials cratered in 2008 after the Lehman Brothers bankruptcy, the weighting to this sector in market capitalization weighted benchmarks shrunk. But RAFI indexes maintained a significant weight in financials because the fundamental factors indicated that the true economic footprint of the sector was greater than indicated by the market capitalization (the use of five-year average cash flows, sales, and dividends in the index methodology also moderated any downsizing of the sector). When financials bounced back after the markets bottomed out in early 2009, the “overweight” position of RAFI products generated alpha relative to many cap-weighted benchmarks [see Does Your Portfolio Need A RAFI ETF?].

The RAFI system can also work out well in protecting portfolios from bubbles. At the height of the tech boom in the early 2000s many cap weighted benchmarks maintained significant exposure to technology stocks, exacerbating the losses when the bubble burst. PRF wasn’t around back then, but because the RAFI methodology takes into account cash flow and dividends, it likely would have maintained a considerably lower weighting in the tech sector than other cap-weighted products.

RAFI ETFs

In addition to PRF, PowerShares and Research Affiliates have teamed up on a number of RAFI products, including a small/mid cap U.S. fund (PRFZ), emerging markets ETF (PXH), ex-U.S. developed markets (PXF), ex-U.S. developed markets small/mid cap (PDN), and Asia Pacific ex-Japan (PAF).

ProShares also recently launched an ETF that employs the RAFI methodology. The ProShares RAFI Long/Short (RALS) is linked to an index designed to exploit inefficiencies of market cap weighting. RALS introduces short selling to the equation in an attempt to capitalize off of discrepancies between the weightings suggested between market capitalization weighting strategies and the RAFI methodology. Basically, the fund will establish long positions in stocks for which the RAFI weighting is larger than the cap weighting and short positions in those for which the cap weighting is larger than the RAFI weighting [see Inside The RAFI Indexes].

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Disclosure: No positions at time of writing, photo is courtesy of user Edg2s.