This article is part of our Innovative ETFs series, where we will discuss exchange-traded products (ETPs) that are seen as innovative—either they use a newly-invented strategy or process to track their index, or they attempt to improve upon existing strategies. Conventional investing wisdom states that you shouldn’t invest in anything you don’t understand. In fact, many say that if you can’t understand it within 5 minutes then it’s probably not for you. Our intention here is to break down the specifics of these innovative ETFs, leaving you with a better understanding of their potential benefits and risks. If at the end of this article you’re still not clear on how this ETF works or whether it’s suitable for your portfolio, then it’s probably not right for you.
Understanding Fundamental Indexing
This article will explain fundamental indexing and drill down into some of the specific characteristics of the PowerShares FTSE RAFI UK 100 (PSRU). This ETF is one of a series of UK-listed ETFs that tracks “fundamental” indices offered by PowerShares.
Fundamental indexing means using accounting measures, rather than other more conventional metrics such as market capitalisation, to size the constituents of an index. It represents something of a middle ground between active and passive investment. It is passive in the sense that it is a rigid, rules-driven approach to constructing a broad basket of securities, but in so doing it aims to outperform its capitalisation-weighted counterparts. The key advantage of fundamental indexing is that it avoids the capitalisation-weighted methodology’s tendency to put more weight on already overvalued securities. But there are shortcomings to fundamental indexing, too; while it doesn’t get as taken in by overhyped market darlings, it also overlooks information about how the market views a company’s growth prospects. Also, it often takes on different types of risk, over-representing value stocks and less liquid names.
PowerShares offers a number of UK-listed ETFs referencing FTSE RAFI indices conceived by fundamental indexing firm Research Affiliates. The indices are constructed by attaching a fundamental value to all the securities within a particular market. These scores are based on each company’s revenue, cash flows, dividends, and book value. The first three metrics are based on an average level over the last five years. Stocks are then ranked by their fundamental value, and the highest scoring ones are selected for the index. Each stock’s weight in the index is proportional to its fundamental score so that the largest companies, as measured in those accounting terms, are given the biggest weight. The scores are recalculated and the index rebalanced on an annual basis. In many of the indices, individual security weights are capped quarterly at 10%.
PowerShares FTSE RAFI UK 100 ETF vs. iShares FTSE 100 ETF
To get an idea of the differences that can emerge between fundamental and capitalisation weighted indexing, let’s look at the PowerShares FTSE RAFI UK 100 ETF versus one that references a market capitalisation weighted counterpart, iShares FTSE 100 (ISF).
In many respects the funds are quite similar in their composition. They each, as their names suggest, hold shares in 100 companies, with a roughly equivalent weighted average market capitalisation. One area where the two funds differ is in their levels of portfolio concentration. As of December 31, 2011 the PowerShares fund had roughly 42% of assets within its top five names, versus 32% for the iShares fund, implying that the RAFI portfolio carried more idiosyncratic risk. Counterbalancing the considerable exposure to its very large top holdings, the PowerShares product had more small cap constituents than the iShares fund. At the portfolio level, it also tilted more towards the value area of the Morningstar Style Box, whereas the iShares FTSE 100 was right in the middle between value and growth.
On a sector basis the two funds were broadly similar. The biggest area of difference was the Materials sector, where the iShares fund had a significantly higher allocation, perhaps implying a more cyclical tilt to the portfolio. The RAFI portfolio had a larger exposure to Financials and Telecommunications.
From January 2008 through the end of March 2012, the two funds have shown correlation to one another of 95%, though the PowerShares fund has not fared as well as the other. Its cumulative return over that period is -1.88%, versus a gain of 3.54% for the iShares product. The PowerShares fund has also exhibited higher volatility, and experienced a steeper drawdown during the financial crisis. Some of this was down to sector positioning that resulted from its value tilt. At the depths of the crisis it had exposure to the Financials sector of 28.4%, versus just 14.6% for the iShares fund.
Of course, the track record covers too short a time period from which to draw meaningful conclusions. The PowerShares fund will have to build over time the case that it can outperform conventional, market capitalisation-weighted counterparts. For now, the idea behind the fund has some compelling advantages, although it may also carry new risks.
With a total expense ratio of 0.50%, the fund is only 10 basis points more expensive than the iShares product, so it could represent an inexpensive way to take on a different set of risk factors with some chance of outperforming a traditional passive index exposure. As usual, investors will have to think about where this fund fits into their entire portfolio. If, for example, it provides some extra small cap and value exposure rather than large cap core, broad-based beta, it should be viewed in the context of the overall portfolio, with the intent of creating a balanced overall mix.
