Finding Value in the Fundamental Index ETFs

Roger Nusbaum submits: Marketwatch has an article about some of the recently listed ETFs that weight based on some sort of fundamental screen. There are several ETF companies doing something along these lines with the two most notable being the RAFI funds (Robert Arnott's method) from PowerShares and WisdomTree's dividend weighted funds.

The article gives the pro side of the argument which is that the back testing is superior to the more popular indices and also noted the flaws of cap weighting of which there are several. On the negative is that back testing is not real world and there are some big gun quotes from Jack Bogle and Burton Malkiel that basically says that people have tried to invent better mousetraps before and they end up not working out.

The first ETF from Arnott (PRF) is only about nine months old which is not a whole lot of time. I wrote about the fund for TheStreet.com last January and was impressed by the back test results but wondered whether or not PRF might quack like a small cap value duck. That comment motivated Arnott to call me on the phone to tell me why I was wrong.

This chart compares PRF, SPY and iShares S&P Small Cap 600 Fund (IJS) which is the small cap fund I compared it to in that Street.com article from January.

While there have been some divergences along the way, I don't think the small cap idea is the single dumbest thing I have ever written either.

Over the last three months the correlation between PRF and IJS has been 0.93 compared to a 0.953 correlation to SPY over the same time period.

PRF does target itself as a replacement for a cap weighted S&P 500 Index fund -- at least that's my perception. Clearly PRF has outperformed SPY by a wide margin for such a short time. While that is nice, I should note, that the volatility has been similar to the S&P 500. PRF's standard deviation has been 11.03 while SPY's has been 11.18, according to PortfolioScience.com.

For now, I am inclined to think there is value in these Fundamental Index funds. That does not have to mean they should be bought at the exclusion of everything else. My approach to portfolio construction to blend together holdings that respond to differently to market current events. No doubt, in the context is constructing a diversified portfolio I, and you too, own stocks that meet the RAFI criteria as well as some names that meet the criteria of the dividend weighted funds from WisdomTree.

In that context, do-it-your-selfers not wanting single stock exposure can now add a different type of ETF to their mix. I don't think the risk here is unreasonable, but I wouldn't suggest you put half your money into one of these either.

Comments

[WC Whiner:]

Sorry, I had to give you 1 star. An analysis of investment management with no discussion of fees is like talking about the Bugatti Veyron without mentioning its price tag. PRF charges you 60 bps, while VTI charges 7. In order to make the former worth your while, you need to be convinced it will outperform the broad market by over 0.5% per year -- quite an alpha for a mechanical management style.

Now, Arnott claims 200 bps of alpha, which would make his vehicle more than worth its fees. I am skeptical, for the obvious reason that that much alpha just shouldn't be available to a mechanical strategy. Indeed, seekingalpha itself carried the FAJ critique of his backtest, noting, "A Fama-French 3 factor regression shows the Fundamental Indexes have exposure to the value factor and, to a lesser extent, the size factor. Accordingly, the Fundamental indexes, net of the value and size factors, earned an estimated alpha of -0.1 percent."

Bored, I did a quick regression. PRF does indeed show a nice alpha vs VTI since inception, ~0.1% per week, which is awfully nice work after fees. I predict it won't last past the next few years, but if it does, I shall be only too glad to eat my words.

2006 Oct 05 05:17 PM

[Robert S:]

(I know it's been 5 months since your post but...) Have you noticed how PRF is practically identical to IVE?

2007 Mar 09 10:52 AM

[Roger Nusbaum:]

too funny, i was just thinking about revisiting PRF. I guess with all the fanfare I might have expected something a little better but the tracking of the two is uncanny.

2007 Mar 09 12:24 PM