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Gain International Value Stock Exposure With This Fundamentally Weighted ETF

This international fund bets on valuation mean reversions by severing the link between a stock's price and its portfolio weight.

Adam McCullough, CFA, 12/23/2016

PowerShares FTSE RAFI Developed Markets ex-US ETF PXF offers broad, well-diversified exposure to large- and mid-cap developed international equities through an unorthodox approach. Instead of weighting its holdings by market capitalization, the fund weights them by fundamental measures of size, which introduces a contrarian rebalancing technique. This approach allows the fund to efficiently profit from mean reversion in valuations, which should provide an edge over its peers. However, there are cheaper alternatives, limiting the fund’s Morningstar Analyst Rating to Bronze.

The fund starts with the FTSE Developed All Cap ex US Index and selects the largest 1,000 stocks based on their fundamental weight rather than market capitalization. To determine a stock’s fundamental weight, FTSE measures its trailing five-year average sales, cash flow, dividend (if applicable), and most recent book value against the aggregate value of each figure for the portfolio. Next, it averages those figures to set the fundamental weight. When it rebalances annually in March, the fund increases its exposure to stocks that have gotten cheaper relative to their peers based on their fundamentals, and trims positions that have become more expensive. The fund effectively bets against the market by rebalancing this way. This approach gives the fund a value orientation, but could also cause it to overweight stocks with deteriorating fundamentals since it ignores forward-looking market prices.

Although the portfolio is value-oriented, its exposure to value stocks isn’t consistent because it doesn’t explicitly target them. In addition, the fund holds growth stocks because its approach doesn’t eliminate them completely, just has less exposure to them than market-cap-weighted strategies. This helps the portfolio maintain broad diversification. The fund doesn’t constrain its country or sector weightings.

So far, the approach has paid off. Since the fund’s inception in June 2007 through November 2016, it has outpaced the foreign large-value Morningstar Category average by 58 basis points annually. Favorable exposure to the materials and utilities sectors contributed the most to its outperformance.

Fundamental View
Research Affiliates, the creator of the fund’s index, argues that market-cap-weighted indexes are not the best way to invest in equities because they link portfolio weightings to stock prices, which don’t always accurately reflect fair value. As a result, market-cap-weighted indexes overweight more expensive stocks and underweight cheaper stocks. Fundamental indexing proponents dub stocks’ random straying prices as the “noisy market hypothesis,” an alternative theory to the efficient market hypothesis. Fundamental indexing strives to sever the link between market prices and portfolio weightings. Instead, it weights its holdings by economic metrics such as earnings, sales, dividends, and book value to reduce exposure to expensive stocks.

In his paper, “Why Fundamental Indexation Might--or Might Not--Work,” Morningstar's Paul Kaplan highlights that fundamental indexing implicitly assumes that all companies should trade at the same valuation multiples. Efficient market advocates counter that stocks should, and empirically do, trade at different multiples based on their risk and growth profiles. Kaplan also asserts that without knowing a stock’s fair value or fair valuation multiple beforehand, it is impossible to conclude in advance that a stocks’ current market price is too high or low, and whether stocks that command high valuations are overpriced.

Research Affiliates points out that there is nothing special about the fundamental weightings in the index--they simply serve to break the link between price and portfolio weightings, and allow the strategy to rebalance into stocks as they become cheaper relative to their fundamentals. It argues that this is a more efficient form of value investing. This strategy is more broadly diversified and representative than traditional targeted value-oriented funds, because unlike traditional value funds, it holds growth stocks, but at smaller levels than market-cap-weighted funds.

Breaking the link between a stock’s price and its weight increases the portfolio’s turnover and trading costs. Market-cap-weighted funds’ holdings naturally move with the ebbs and flows of the market. However, this fund requires higher turnover to rebalance back to its fundamental weightings each year. Even with this alternative weighting technique, the portfolio’s average five-year turnover is only 16%, nearly one third of the category average. The strategy uses the five-year average for each fundamental metric to reduce turnover. But while this reduces turnover, it could cause the fund to hold stocks with deteriorating fundamentals because it relies on backward-looking metrics to weight its holdings rather than price, which incorporates a forward view of a company’s outlook.

Adam McCullough, CFA, is an analyst on Morningstar’s manager research team, covering passive strategies.

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