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.
Since RAFI was basing its weighting based on a four year – excuse me a five year average, during that time period it continued to maintain a similar weighting to the financials, and actually even increased a little bit. Because even though the stock prices were still falling to the single digit, the company size based on its economic footprint of book value, dividends, cash flow and sales, they were still large companies as part of the U.S. economy.
So, the FTSE RAFI weighting in financials actually went up slightly when it rebalanced in March of 2009 and then you get the huge recovery in the financial stock. So, has that value tilt bias to it, but again it's a dynamic value tilt.
Rawson: Another fund that has performed similarly to PRF is the Rydex S&P 500 Equal Weight RSP. However, whereas PRF has a little bit of a value tilt, RSP is a little bit more of a small cap tilt. Between value and small cap how do you see these two areas of the market performing over the next few years?
McRedmond: Well, I mean, I'd hate to – who'd want to make a market call on those, but I guess I could say that if you look at the RAFI fundamental methodology compared to an equal weighted methodology, if you go back and research historically, what you'll find is that they both have similar value adds as far as their outperformance compared to a tradition cap-weighted index but the return stream is certainly different as you said. The RAFI will have maybe more of that value bias to it, while the equal weighted is much more of a small cap bias.
The things to keep in mind with that is while we would expect that both of them would add value over time compared to a cap-weighted index because they both – the thing that they both do in common is that they break that link between the weighting that a company gets in a cap-weighted index compared to the fundamental or the equal weighted.
So, just by mathematics, a cap-weighted index is always going to be overweight and overvalued company and underweight and undervalued company. The more the price goes up, the more and more the cap-weighted index is going to own it.
So, both methodologies just break that link and that's really kind of where the value comes. But the thing to the FTSE RAFI compared to the equal weighted is that one, lower turnover – so it's much more in line with the traditional low turnover beta S&P 500, Russell 1000 index because it has much lower turnover compared to a cap-weighted index and the other thing is investment capacity. An equal-weighted index is going to have the same weighting to an Exxon Mobil as it does to an H&R Block. Exxon Mobil has huge liquidity. H&R Block does not. So, those issues.
Rawson: Right. Certainly, the whole world can't move to an equal-weighted index.
McRedmond: Right, exactly.
Rawson: Whereas potentially the whole world couldn't move to an economic footprint type of weighting.
McRedmond: I don't know about the whole world, but it's got a lot more room to get there than an equal-weighted strategy does.
Rawson: Absolutely. We talked a little bit about fundamental and enhanced ETFs. Active ETFs haven't really taken off yet in the marketplace. How do you categorize the FTSE RAFI ETF, is it active or is it passive in your view?
McRedmond: Well, in our view, and I guess in the view of the SEC too, they track an index, so therefore they are passive. What we always like to say is that even if it's an index-based product and tracking an index, and therefore by definition passive, the index construction methodologies are different. Some indexes are more active, if you will, in their construction of the index methodology than a traditional benchmark index.
So, in our mind, it's definitely a passive approach because it's index-based and it maintains those characteristics as I said before that a passive strategy has which is the low turnover and the large capacity for investment.
Rawson: Okay. So where does this type of portfolio fit into an investor's overall portfolio?
McRedmond: We look at it as being an alternative beta source. RAFI has generated alpha over time, but it's not so much how you'd traditionally define alpha. It's not seeking to generate alpha. Alpha is sort of just the result of the different index methodology. So, we look at it as being again an alternative beta source, that's a great complement with your traditional cap-weighted indexes. And I think that goes in line with the few things that you've seen, I guess, it was just a little less than a year ago, Watson Wyatt, which was a big Institutional Consulting Group, now Towers Watson through mergers.
They came out with the report and they looked at fundamental indexes and cap-weighted indexes and their conclusion that they were going out to their clients, their consulting clients was, that over time these alternative beta sources of fundamentally-weighted indexes should or could represent up to 50% of your weighting. But again it made sense that they weren't saying that one is always better than the other, but what they were saying is it makes a lot of sense to use both of them in conjunction with each other because what you're going to wind up with are going to be better risk-adjusted returns for the overall portfolio.
So, we certainly approach it as being a core holding in addition or in complement to the traditional cap-weighted, but at the same time you certainly have people – more institutional investors who might use it in a tactical sense. We see some people who will use it in long-short strategies, long a fundamental, short the cap-weighted and just trying to capture that historical value add to the fundamental-weighted indexes.
Rawson: Might be a difference in semantics, but I would classify it as more of a satellite holding, certainly one you could hold for a long period of time. And you also want to make sure that if you are going to buy this fund, you do want to look at what are the value funds or value manager of various stocks you have in your portfolio, because it is also going to give you some value tilt.
Well, thanks Ed for joining me.
McRedmond: Thank you, Mike. I appreciate it.
Rawson: I'm Mike Rawson with Morningstar. Thanks for listening.