The exchange traded fund PowerShares FTSE RAFI US 1000 (NYSEArca: PRF) is described as delivering active returns with a passive discipline. The secret to this fund’s approach is in the indexing methodology.
PRF has a five-year annualized return of 6.8% compared with 5% for the S&P 500, according to Morningstar. However, the ETF does have a slightly higher standard deviation over that time at 22.6 compared with 18.9 for the S&P 500, according to the firm’s data.
The fund’s tracking index was designed by Research Affiliates. The firm’s chairman and founder is Robert Arnott. RAFI stands for Research Affiliates Fundamental Index.
Fundamental indexing is an approach that avoids weighting companies by market cap like most traditional stock benchmarks, Arnott explained at the 2013 ETF Virtual Summit.
Market-cap-weighted indices mirror the market but their “Achilles’ heel” is that the most money is allocated to the most-loved companies with the highest stock price, or the stocks with the greatest growth expectations and loftiest valuations, he asserted.
“Why not index companies based on how good their business is?” Arnott said.
He said fundamental indexing weights companies by their economic footprint and creates a value tilt relative to the market. Also, the indices are constantly re-weighted, which takes advantage of premiums and discounts in the market to economic footprint.
Fundamental indexing “turns volatility into incremental return,” Arnott explained. Boosting returns by a couple percentage points annually with the approach can make a “big difference” over 20 years, he said.
“Unlike most index funds, PRF weights its holdings based on fundamental measures of size, including book value, cash flow, sales, and dividends, rather than market capitalization. Proponents of fundamental indexing argue that these metrics better capture a firm’s economic footprint than does market capitalization, which can diverge from fundamental value,” Alex Bryan wrote for Morningstar.
PRF avoids overexposure to expensive stocks, which some argue can happen with traditional market cap weighting. The tendency to underweight cheaper stocks then leaves investors underexposed to growth potential, which can rob a portfolio of gains in this department. However, some critics argue that fundamental indexing is a re-packaged value strategy, since most fundamental indexes contain a value tilt, reports Bryan.
Another means to a fundamental indexing strategy comes with an equal-weight index. This is when all of the stocks within the index are given the same amount of allocation. This method is known as “contrarian” but it also tends to go through a higher turnover rate. [New Equal-Weight Emerging Market ETF]
PRF is good for a buy-and-hold investor that can handle a bit of risk. The payoff comes with exposure to companies that can add value to a portfolio by minimizing exposure to established, expensive companies. The small-cap value tilt makes it a good performer during market uncertainty or downturns, while offering outperformance during a healthy market cycle. [Are Investors Loyal to an ETF’s Index?]
Over the long term, value strategies tend to offer risk-adjusted returns and higher total returns than the broad market.
PRF does not lower exposure to stocks whose valuations contract or blindly add to its positions in stocks that become more expensive. Rather, it attempts to replicate an active manager’s strategy of adding to positions that become cheaper and paring back positions as they gain value. This contra-trading approach, which is buying on weakness and selling on strength, helps the fund profit quickly from market mispricing than cap-weighted value funds, as value stocks may remain out of favor for years, explains Bryan.
The 0.39% expense ratio is reasonable, especially when one considers PRF to have attributes of active management. [Focus on Value with Large-Cap ETFs]
PowerShares FTSE RAFI US 1000
Tisha Guerrero contributed to this article.