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By Michael Rawson, CFA | 01-14-2011 02:46 PM

Index Investing With a Value Tilt

PowerShares' Ed McRedmond explores how non-cap-weighted indexes can give investors better bang for their indexing buck.

Michael Rawson: Hello. I'm Mike Rawson, ETF Analyst with Morningstar. ETFs still seem like a cutting edge area of the markets, but a number of fundamentally or enhanced index weighted ETFs have been around for five years or more. One such fund is the PowerShares FTSE RAFI 1000 ETF.

The fact that it's been around for five years gives us time to look back and see if the fund has delivered as promised.

Joining me today is Ed McRedmond. He is the Senior Vice President of Institutional & Portfolio Strategies with PowerShares.

Ed, thanks for joining me.

Ed McRedmond: Thanks for having me, Mike.

Rawson: Okay, PRF, the PowerShares FTSE RAFI 1000 ETF is often dismissed it's just a value fund or value strategy, but it has performed better than the Russell 1000 value both on a return basis and a risk adjusted return basis. Is there something more to it than just valuation?

McRedmond: Yeah, definitely. I think what you have going on there is that, well, while it definitely has a value tilt to it historically. And it also will have somewhat of a cap bias. In that, it's not as focused on mega cap as your traditional cap-weighted indexes. But particularly the value tilt is dynamic.

And what I mean by that is, if you look back historically, the weighting or the tilt towards the value has been greatest when you'd want it to be. So, as an example, in the late 90s till the 2000 the midst of the tech bubble the FTSE RAFI methodology, what you saw was that, it was increasing its weighting during that time period when it would rebalance to what would be considered value stocks because the weighting was being assigned based on the four fundamental factors and not the fact that the stock price was going up.

So, when you had Cisco being the largest weighting in the S&P 500 at the peak in 2000 and about 4.5% weighting, you had Cisco in the FTSE RAFI US 1000, but its weighting was much smaller because it was based on Cisco's economic size, based on those fundamentals. So it was may be 0.4%, 0.5% weighting. Its weighting had increased as their fundamentals have gone up, but not to the extreme nature that you saw in a cap-weighted index.

Then if you go forward a few years after the bubble burst, and value stocks had a big run up, again through the rebalancing process, the value tilt to the RAFI actually would've come down.

So again, that value tilt, it's definitely their over time, but it's not static, it's dynamic and sort of the flip side of that is what you saw occur at the end of 2008, 2009 where you had the crash in the financial stocks.

What you saw in the cap-weighted indexes was obviously as the Citis and the BofAs fell down to single-digit stocks. The weighting went from the highest weighting in the S&P 500, down to less than half of it was at the peak. So, when they go to rebalance at the end of 2008, beginning of 2009 it's just as those companies are turning around is when the cap-weighted index had the lowest weighting to them in a number of years.

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