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By Alex Bryan

Index investing has its advantages: low costs, tax efficiency, and transparency. Yet, if market prices are not always rational, it may not be ideal to weight each stock in portion to its market capitalization, as most indexes do. Blindly adopting market-cap weightings may cause investors to reduce their exposure to stocks that are trading below their fair value and increase their holdings of expensive growth stocks. PowerShares FTSE RAFI US 1000 (NYSEARCA:PRF) is designed to address this potential problem, while retaining the benefits of a traditional index fund.

Unlike most index funds, PRF weights its holdings based on fundamental measures of size, including book value, cash flow, sales, and dividends, rather than market capitalization. Proponents of fundamental indexing argue that these metrics better capture a firm's economic footprint than does market capitalization, which can diverge from fundamental value. According to this line of reasoning, market-cap weighting tends to overweight expensive stocks and underweight cheaper names.

Efficient-market advocates and other critics dismiss fundamental indexing as a repackaged value strategy. Most fundamental indexes, including PRF, exhibit a value tilt. However, Christian Walkshausl and Sebastian Lobe's 50-country study covering 1982-2008 found that fundamental indexing added significant excess returns globally, even after controlling for value and other risk exposures. Fundamental indexes’ contrarian bent may contribute to this superior performance. PRF pares back its exposure to stocks whose valuations expand relative to their peers and increases its exposure to those whose valuations compress. Funds based on equally weighted indexes offer a similar contrarian strategy, though they tend to experience higher turnover. These bets against the market have made PRF slightly more volatile than the Russell 1000 Index over the past five years.

PRF is a suitable core holding for long-term investors who can stomach a little extra volatility to capitalize on potential market mispricing. This strategy can add value by reducing exposure to expensive growth stocks. Over the long run, betting on value has paid off handsomely in nearly every market. Research suggests that investors tend to extrapolate recent growth too far into the future, which can cause prices to diverge from fundamental value. PRF counters this bias by anchoring its weightings in each company's proven capacity to create value. Given its small-cap and value tilts, PRF will likely underperform during market downturns and outperform during bull markets. It can also offer some protection against growth-oriented market bubbles.

Fundamental View
According to a paper by Paul Kaplan, "Why Fundamental Indexation Might--or Might Not--Work," fundamental indexes make the implicit assumption that all holdings should trade at the same fair value multiples. However, different levels of risk and growth could justify different fair value multiples, which may cause a fundamental index to misrepresent a firm's true fair value in its weightings. Market prices reflect differences in risk and expected growth, but--as the proponents of fundamental indexing argue--market prices are noisy and may diverge from fundamental value. Kaplan asserts that in order for a fundamental index to outperform a market-cap index, market-valuation errors would need to be more variable than differences in the justified fair value multiples. This may be a fair assumption for stocks at the extremes of the valuation spectrum (deep value and high growth). Historically, value stocks have offered superior risk-adjusted returns and higher absolute returns than the market over the long run. Because PRF has an overweighting in these stocks, it should follow a similar return pattern.

In essence, fundamental indexing is an enhanced value strategy. However, unlike a traditional cap-weighted value index fund, PRF does not reduce its exposure to stocks whose valuations compress or blindly add to its positions in stocks that become more expensive. Rather, it attempts to replicate an active manager's strategy of adding to positions that become cheaper and paring back positions as they appreciate. This contra-trading approach (buying on weakness and selling on strength) helps the fund more immediately profit from market mispricing than cap-weighted value funds, as value stocks may remain out of favor for years. For instance, since its inception in December 2005, PRF has outperformed iShares Russell 1000 Index (NYSEARCA:IWB) by about 1% annualized, despite its higher fee. Notably, during this time most value strategies (including iShares Russell 1000 Value Index (NYSEARCA:IWD)) have underperformed. Because of its value tilt and contrarian approach, there is a good chance that PRF will outperform the market-cap-weighted Russell 1000 Index over the long-run.

Despite the fund’s value tilt, it currently looks fairly valued based on Morningstar equity analysts’ assessments of the fund’s underlying holdings. However, our equity analysts believe there is room for robust top-line growth as the U.S. economy strengthens. The U.S. economy has been surprisingly resilient over the past few years. Households and companies have reduced their leverage in recent years, consumer spending is reasonably healthy, inflation is low, manufacturing activity and oil production have picked up, and the unemployment rate has continued its gradual decline. Renewed strength in the housing market could continue to drive the recovery forward and further bolster consumer spending.

Portfolio Construction
PRF employs full replication to track the FTSE RAFI U.S. 1000 Index. This benchmark includes the 1,000 largest U.S. companies from the FTSE US All Cap Index, as measured by fundamental value. In order to assign each stock’s fundamental value and weight in the index, FTSE RAFI calculates the percentage weight of each stock’s cash flow, sales, dividends (where applicable), and book value, against the aggregate values of each of those metrics. To reduce turnover, the index uses five-year averages for each factor, except book value. FTSE averages those four values to assign each stock’s weighting in the index. For those stocks that do not pay dividends, the average of the other three factors determines the stock’s fundamental weighting. This approach tilts the portfolio toward value stocks. Relative to the Russell 1000 Index, PRF has overweightings in financials and underweightings in technology stocks. The index is reconstituted annually in March.

Apple (NASDAQ:AAPL) provides a prime example of this fundamental weighting approach. While Apple currently has the largest market cap of any U.S. company, giving it the top spot in most large-cap index funds, it is PRF's 29th largest holding. That’s because Apple’s dramatic rise in revenue, cash flow, and dividends has had less of an impact on the five-year averages of those metrics.

Fees
While the fund’s 0.39% expense ratio is slightly higher than the U.S. ETF large-value category average, it is reasonable for the fund’s unique strategy. Over the past five years, the fund has lagged its benchmark by roughly the amount of its expense ratio. However, the fund’s turnover and trading have created costs that can be higher than its market-cap-weighted counterparts. Over shorter horizons, these trading costs have added a small drag on the fund’s returns. The fund engages in limited securities lending, the practice of lending out the underlying shares in exchange for a fee. This ancillary income partially offsets the fund’s expenses.

Alternatives
Schwab Fundamental U.S. Large Company Index (SFLNX) (0.35% expense ratio) is the closest alternative. It tracks the Russell Fundamental U.S. Large Company Index, which is also based on Research Affiliates’ methodology. However, in contrast to the index PRF tracks, the Russell version excludes book value and includes share buybacks in its fundamental weight calculations. Additionally, the Russell index includes fewer constituents and offers a greater large-cap tilt. These adjustments tend to give SFLNX greater exposure to technology stocks and less exposure to financials than PRF has. However, over the past 10 years, their indexes were 0.99 correlated.

A dividend-weighted index, such as WisdomTree LargeCap Dividend (NYSEARCA:DLN) (0.28% expense ratio), might be a more suitable fundamental index alternative for investors looking for income. WisdomTree weights each holding in DLN by the dollar value of dividends the company is expected to pay out over the next year as a share of the aggregate projected dividend stream of all the companies in the fund. This approach balances dividend yield against market capitalization and skews the portfolio toward large-cap companies.

Institutional investors with $1 million or more might consider PIMCO Fundamental IndexPLUS Total Return (PXTIX) (0.79% expense ratio). PXTIX tracks the eRAFI, which adds a series of earnings quality adjustments to the original RAFI weighting methodology. It uses swaps to get exposure to the eRAFI and invests most of its assets in a portfolio similar to that of PIMCO Total Return (PTTAX). This complex strategy makes PIMCO Fundamental IndexPLUS Total Return a riskier alternative to PRF, but it can offer higher returns.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: PRF: Active Returns With Passive Discipline