Are Fundamental ETFs Better?

We chose to examine one of the largest PowerShares/RAFI ETFs, the PowerShares FTSE RAFI US 1000 Portfolio (PRF). PRF has $2.35 billion in assets under management, has average daily dollar volume of over $8 million and almost never trades at a noticeable premium or discount to its net asset value, indicating the fund is sufficiently liquid.

PRF competes directly with the $7.97 billion iShares Russell 1000 ETF (IWB). Both funds feature ExxonMobil as one of their top holdings, but Apple is not even a member of PRF’s top 10 lineup. There are noticeable differences at the sector level as well. IWB has an 18.48% weight to financials and a 9.77% allocation to energy stocks. Those sectors account for 21% and 11.9% respectively, of PRF’s weight. IWB is the less expensive with annual fees of 0.15% compared to 0.39% for PRF.

Low expense ratios are often a source of allure for ETF investors, and if all things were equal, then IWB would be the easy choice. Everything is not equal in this comparison, particularly when it comes to how PRF’s use of book value, cash flow, sales and dividends as screening factors has led to noticeable, long-term performance differentials.

An investor that had put $100,000 into IWB five years ago would have roughly $140,000 today. Not too shabby, but the investor that opted for PRF would have over $160,000 today, enough of a gap to render the expense ratio difference a moot point. For those with a preference for narrower time frames, PRF has easily topped IWB over the past 12, six and three months while being only slightly more volatile.

Embracing Fundamentals

Fundamental indexing is gaining a more prominent place in ETF menus.

In August, Charles Schwab unveiled six new Schwab Fundamental Index ETFs that charge annual expense ratios between 0.32% to 0.46%. The new ETFs are linked to the Russell Fundamental Index Series, which is based on methodology developed by Rob Arnott and Research Affiliates.

“We’re here to help advisors and investors alike recognize that Fundamental Index funds—whether ETFs or mutual funds—are a thoughtful way to gain broad industry exposure, right alongside their market cap-weighted counterparts,” said Marie Chandoha, president of Charles Schwab Investment Management. “We believe the systematic approach inherent in fundamentally weighted methodologies, when used alongside cap weighted strategies, enables investors to diversify and balance their exposure.”

Conclusion

The PRF/IWB comparison is just one example of differences that fundamental versus market cap weighting can make. It should be noted that not all fundamentally weighted ETFs outperform their cap weighted rivals. Still, there are notable examples of outperformance by fundamental ETFs. The PowerShares FTSE RAFI US 1500 Small-Mid Portfolio (PRFZ) has beaten the iShares Russell 2000 ETF (IWM) by more than 400 basis points over the past year.

According to the Independent Advisor Outlook Study by Schwab Advisor Services, 59% of its RIA clients currently invest in fundamentally weighted products, and roughly one in five plans to invest more in the near term.

It would be erroneous to see fundamental weighting as the “holy grail” of ETF construction. However, it is evident that some fundamental ETFs have a worthy place in client portfolios over cap weighted products.