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An Enhanced Value Strategy Gives This ETF an Edge

Alex Bryan, CFA

Alex Bryan: PowerShares FTSE RAFI US 1000 ETF (PRF) offers a distinctive value strategy. It invests in a broad swath of large- and mid-cap U.S. stocks. However, rather than weighting them by market capitalization as most index funds do, it assigns weightings according to fundamental measures of size, including sales, cash flow, book value, and dividends (where applicable). This introduces a value tilt in two ways: First, it causes the fund to overweight stocks that are trading at low multiples with these metrics and underweight more expensive stocks relative to a market-cap-weighted benchmark.

Secondly, fundamental weighting causes the fund to increase its exposure to stocks that have become cheaper relative to their peers when it rebalances and trim back on positions that have become more expensive. These disciplined bets against the market may help the fund more effectively profit from mean reversion in valuations than market-cap-weighted value funds. However, they can also increase its exposure to stocks with deteriorating fundamentals because accounting metrics are usually slower to pick up on that than market prices.

From its inception in December 2005 through June 2015, the fund has outperformed the Russell 1000 Value Index by 1.4% annualized. But most of this outperformance occurred during 2009, partially as an accident of timing. The fund rebalanced in March 2009, increasing its exposure to the most beaten-down stocks around the time they reached bottom. When the market started to rebound, these stocks outperformed. Had the fund rebalanced at some other time, its performance advantage probably would have been smaller. While the fund will likely have a smaller edge going forward, its disciplined rebalancing approach can still help, particularly when valuations are unusually high or low.