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A New Approach to Fundamental Weighting From Invesco

These new funds aim to deliver value exposure without the value traps.

In September 2018, Invesco launched a suite of five "Strategic" exchange-traded funds. These new funds track benchmarks that were developed by Invesco's internal index group, which was formed in 2017. The new lineup builds on the company's legacy as a pioneer in offering non-market-cap-weighted approaches to building index portfolios. Here, I'll take a closer look at the methodology behind these new indexes and compare them to their closest cousins within the Invesco stable.

A Brief History Lesson Invesco, by way of its 2006 acquisition of the ETF sponsor formerly known as PowerShares, was among the first ETF providers to offer funds tracking indexes that weight their stocks based on something other than market capitalization. Guggenheim, whose ETF business Invesco acquired in 2018, was the first. It was actually Rydex, which was subsequently acquired by Guggenheim, that launched what is now Invesco S&P 500 Equal Weight ETF RSP, in April 2003--the first non-market-cap-weighted ETF. About a week later, PowerShares debuted the fund now known as Invesco Dynamic Market ETF PWC. The fund was underpinned by a member of the Intellidex index family. These indexes were created by the American Stock Exchange, which has since been acquired by the New York Stock Exchange. These funds were the first in a wave of second-generation strategic-beta benchmarks. These indexes are fundamentally different from the first generation of strategic-beta indexes in that they select and weight securities based on something other than price. Most do so in an effort to deliver better risk-adjusted returns than their parent index. As such, they represent a form of active management.

A Look Under the Hood of Invesco's Strategic Indexes The Invesco Strategic index suite aims to pick bigger and better stocks and weights them according to the size of their businesses. Each index starts with an investable universe of stocks (U.S. stocks, emerging-markets stocks, and so on). Stocks in this universe are assigned a business-size score. This score is an equal-weighted average of four measures: sales, cash from operations, dividends plus share repurchases, and book value. Each of these values are calculated using five years of data and then standardized as a percentage of the total value for the investable universe. Stocks that are in the top 90% of cumulative size within the selection universe are eligible for inclusion in the index.

Stocks within the selection universe are also assigned a quality score. The quality score is the straight average of two factors: efficiency and growth. Invesco measures efficiency as prior year's sales divided by assets. This indicates how effective a firm is at generating revenue from its assets. The growth measure looks at the change in the sales/assets ratio over the past five years. Firms that have increased this ratio over time are doing an ever-better job of generating business from its assets, which is an indicator of the quality of the enterprise. The 20% of those stocks in the selection universe with the lowest quality scores are excluded from the index portfolio. Omitting these stocks tilts the portfolio toward higher-quality names.

The remaining stocks are weighted based on their float-adjusted business size scores. This tilts the portfolio toward bigger companies, though not necessarily bigger stocks--as price is not part of the equation. Weighting stocks in this manner results in a value tilt.

Value Without the Traps? Putting these new indexes in context can help understand how their approach is distinct from other flavors of fundamental weighting. To do so, I'll stack one of the newcomers, Invesco Strategic U.S. ETF IUS, up against one of the original fundamentally weighted ETFs, Invesco FTSE RAFI U.S. 1000 ETF PRF, which earns a Morningstar Analyst Rating of Bronze.

PRF tracks the FTSE RAFI U.S. 1000 Index. This benchmark includes the 1,000 largest U.S. companies from the FTSE U.S. All Cap Index measured by fundamental size. In order to determine each stock's fundamental size and weighting in the index, FTSE RAFI calculates the ratio of each stock's cash flow, sales, dividends (where applicable), and book value to the aggregate values of each of those metrics. To reduce turnover and the influence of outliers, the index uses five-year averages for each measure except book value, where it uses the most-recent figures. FTSE averages those four values to assign each stock's weighting in the index. For stocks that do not pay dividends, the average of the other three metrics determines the stock's fundamental weighting. The index is reconstituted annually in March. This approach pulls the portfolio toward value stocks.

If PRF and IUS' bogies seem awfully similar, that's because they are. Both cue off 5 years' worth of data for almost identical measures of fundamental size and weight stocks on this basis. The most meaningful difference with respect to how the two measure companies' size is that IUS uses a more expansive definition of cash returned to shareholders, looking at dividends and share repurchases as opposed to just dividends as PRF does. This same more-sweeping metric is used also used by the Russell Fundamental U.S. Large Company Index, which underpins Bronze-rated Schwab Fundamental U.S. Large Company ETF FNDX. Summing dividends and share repurchases is a more complete measure of fundamental size than just dividends, as many firms use both channels to return cash to shareholders. This difference might seem subtle, but it can partly explain why, for example, Apple AAPL represents 3.2% of IUS' portfolio and 2.2% of PRF's. Over the past five years, Apple has spent roughly 3.5 times as much cash on share buybacks as it has paid out in dividends.

The biggest difference between the Strategic index series and its closest fundamentally weighted peers is that it applies a quality screen. Weeding out the lowest-quality stocks from the selection universe will yield a different performance profile versus predecessors that don't apply a similar screen.

One of the potential pitfalls of any value-oriented strategy is the risk of falling into value traps. Value traps are stocks that look cheap but have deteriorating fundamentals that can hurt returns. There might be a light at the end of the tunnel for some these names. For others, that light might turn out to be an approaching train. Applying a quality screen should help to sidestep many value traps, likely resulting in a smoother ride. That said, there are trade-offs. Omitting a fifth of the selection universe could also throw out some cheap stocks that ultimately bounce back. As such, IUS and its siblings will likely have less-pronounced value tilts versus the likes of PRF. The Strategic series will instead favor larger, higher-quality stocks.

The data below corroborate this. IUS' portfolio has a larger average market cap and greater portion of stocks deemed to have wide or narrow Morningstar Economic Moat Ratings versus PRF. Over IUS' brief life, its emphasis on quality has taken a bit of the sting out of the recent market drawdown relative to quality-agnostic PRF. Taken together, IUS' much lower fee, a more comprehensive approach to measuring firms' fundamental size and quality screen make it a compelling alternative to PRF.

Index Construction Matters At the risk of sounding like a broken record: index construction matters. Today, there are nearly 700 strategic-beta ETFs to choose from, and that number will continue to grow. As the number of these funds that attempt to marry the best of both active and passive approaches to portfolio construction keeps expanding, they will continue to become more complex and nuanced. IUS and its siblings in Invesco's new suite of strategic ETFs are just a few of the many examples of this trend and the challenge it poses to investors.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

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