Traditional market capitalization-weighted indices are top heavy and expose investors to some of the most high-flying stocks of the current market. If investors are concerned about the potential risks of an overextended market, consider a revenue-weighted exchange traded fund strategy to focus on companies with better fundamentals.

ETF Trends publisher Tom Lydon spoke with Dave Mazza, SVP of Beta Solutions at OppenheimerFunds, at the 2017 Morningstar Investment Conference in Chicago April 26-28 to talk about smart beta solutions in the growing ETF space.

“There have been $25 billion in flows into smart beta year-to-date already,” said Mazza. “What’s interesting is investors are continuing to look for new strategies, whether or not it’s traditional cap-weighted passive, all the way up to traditional active, but in-between, there’s this new factor space, with smart beta.”

These smart beta ETFs include options that have the potential to outperform traditional cap-weighted indices at a much lower cost than actively managed funds.

For example, at OppenheimerFunds, there is a suite of revenue-weighted ETFs that focus on companies with high revenue generation, such as the Oppenheimer Large Cap Fund (NYSEArca: RWL).

Mazza explained that as the bull market extends, investors tend to forget about valuations and continue to ride high-flying stocks, which may potentially expose investors to risks, such as a quick drawdown.

“What we think might be a better solution: you can still own the whole market, but tilt toward attractively valued companies – tilt toward companies with better fundamentals that just so happens to be higher than market-cap, and that’s what you can do by looking at a revenue-weighted strategy,” Mazza said.

The rules-based, disciplined smart beta indexing methodology targets known indices like the S&P 500 and tries to improve their performance return through weighting each security in the index by top line revenue. Components are then rebalanced every quarter to keep the Revenue-Weighted indices in line with the companies’ most recently reported revenue levels.

Revenue weighting could provide diversified exposure to the market, is not influenced by stock price, reflects a truer indication of a company’s value and offers stable sector exposure. Moreover, revenue weighting may provide a more value-oriented portfolio and historically outperformed in a value-driven market while showing lower drawdowns during growth-driven markets.

By rebalancing toward companies with persistent sales, revenue weighting helps keep a portfolio from overstaying during an overheating market. The result could be a portfolio with better risk-adjusted returns over the long haul.

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