A Closer Look at the RAFI Fundamental ETF Strategy | 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.