ETF Trends
ETF Trends

As investors search for alternative avenues to track the U.S. equities market in an attempt to diminish risks and potential enhance returns, some may turn to fundamental or smart-beta index-based exchange traded funds.

On the recent webcast, Fundamental Index: Inside 10 Years of Excess Return, John Feyerer, Director of Equity ETF Product Strategy at Invesco PowerShares, explains that relatively new breed of smart-beta ETFs employ both passive and active methodologies to potentially diminish risk and provide broad exposure to the equities market. The enhanced, factor-based, smart-beta or fundamental ETFs will passively track an underlying index. However, the underlying index implements actively managed strategies, such as focusing on low-volatility, momentum and value, among others.

“Fundamental index seeks to maintain the benefits of broad market index investing, address the shortcomings of cap-weighted construct and provide a rebalance discipline investors have difficulty implementing themselves,” Feyerer said.

For instance, the PowerShares FTSE RAFI US 1000 Portfolio (NYSEArca: PRF), which has been around since December 19, 2005, ranks among the longest running smart-beta ETFs in the U.S. markets. PRF tracks 1,000 U.S. stocks that show the highest fundamental strength based on the RAFI fundamental indexing methodology, which screens for sales, book value, cash flow and dividends.

Rob Arnott, Chairman and CEO of Research Affiliates, pointed out that in prior market conditions, equity prices may deviate wildly from fair value but cap-weighted indices still beat the majority of active managers. Consequently, investors may be better served by switching away from market cap-weighted indices and weight individual components by other measures.

For example, Arnott explains how the RAFI methodology may tilt toward stocks that show cheaper valuations due to its multi-factor approach and underweight more expensive stocks. Looking at PRF’s holdings, Exxon Mobil (NYSE: XOM) is currently the largest position in the fund’s portfolio at 2.9%. Arnott shows that the RAFI weighting methodology ranks the energy company second in sales, first in cash flow, second in dividends and fifth in book value among the universe of U.S. large-caps. In contrast, the widely popular Apple (NasdaqGS: AAPL) has a 1.3% position in PRF’s portfolio. AAPL has seen prices rise over the years, but the tech company shows less favorable dividends and a pricier book value.

Currently, PRF’s portfolio favors a 22.0% tilt toward the financial sector, along with 12.4% information technology, 11.5% consumer discretionary, 10.7% health care, 10.5% industrials, 10.4% consumer staples, 9.9% energy, 5.3% utilities, 4.0% telecom and 3.2% materials.

Moreover, the smart-beta ETFs will periodically rebalance its positions to account for changes in the valuation metrics to potentially capture excess returns and to lower exposure to pricier segments of the market.

PRF shows a 15.6 price-to-earnings and a 1.8 price-to-book, according to Morningstar data. Meanwhile, the S&P 500 index is trading at a 18.5 P/E and a 2.4 P/B. The fundamental strategy has also slightly outperformed over the years, with PRF generating an average annualized return of 6.8% over the past 10-years, compared to S&P 500’s 6.4% return.

Financial advisors who are interested in learning more about fundamental, smart-beta ETF strategies can listen to the webcast here on demand.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.