The rise of the ETF industry has changed a lot about the business of investing. It has altered the way investors look at expenses, making it difficult to justify handing over 200 basis points (or more) each year to an active manager who can’t regularly beat a benchmark. It has also expanded the universe of investable securities; asset classes that were once available only to the biggest and richest investors (such as hedge fund strategies and commodities) are now readily available to anyone with an online broker.
ETFs have also changed the way investors look at indexes. When indexes were primarily benchmarks used to measure manager performance, few gave much thought to the rules or investment theses governing the construction and maintenance. But as indexes have evolved into (essentially) investable assets, the underlying methodologies have been more carefully scrutinized. As a result of this increased scrutiny, some of the flaws related to existing indexing strategies have been dragged into the spotlight, and a number of “alternative” weighting systems have been devised to address some of these shortcomings (see the Index Database for a complete list of indexes available through ETFs or filter ETFs by index with the ETF Screener).
The Problem(s) With Cap Weighting
Cap-weighted indexes became popular for a number of reasons. For starters, since the allocation to any given security will generally increase with its stock price, these benchmarks are very easy to maintain. Moreover, they make some intuitive sense as a slice of the entire investable universe; if an investor were to own the entire publicly traded stock market, the larger companies would account for a larger portion of total assets.
But there are some drawbacks to cap-weighting as well. Because of the direct link between stock prices and stock weighting, a market cap-weighted ETF will tend to overweight overvalued stocks and underweight undervalued stocks, which can obviously create a drag on returns. The alternatives to cap weighting have been numerous and creative. There are dozens of ETFs based on equal-weighted indexes that give an equivalent allocation to each component company (see Why EQL May Be A Better S&P 500 ETF Than SPY). WisdomTree pioneered ETFs based on indexes that determine allocations using earnings and dividends. And PowerShares teamed up with the folks at Research Affiliates for a line of ETFs based on Fundamental indexes that use four alternative measures of firm size (see Does Your Portfolio Need A RAFI ETF?).
Revenue-Weighted ETFs Surge in Q1
Another option to traditional cap weighted indexes comes from Pennsylvania-based RevenueShares. The idea behind the RevenueShares line of ETFs is pretty simple. These funds hold the same basket of stocks that make up well-known cap-weighted indexes (such as the S&P 500) but use top line revenue, not market cap, to determine the weighting given to each. So theoretically, this methodology will underweight the stocks trading at a high price-to-revenue multiple and overweight those trading at a low multiple.
The distinction between cap-weighted ETFs and revenue-weighted funds seems relatively minor. But it can have a surprisingly large difference on bottom line returns. After whipping their cap-weighted counterparts in 2009, revenue-weighted ETFs have continued their impressive run in 2010. As of March 29, the three broad-based domestic equity funds had added further distance between themselves and the cap-weighted alternatives since the beginning of the year:
The RevenueShares Large Cap Fund (RWL) holds the same securities in the S&P 500, but determines the weight given to each based on top line revenue as opposed to market capitalization. The two ETFs tracking the S&P 500 (SPY and IVV) are both up about 5.3% on the year, while RWL is up more than 8%.
The RevenueShares Mid Cap Fund (RWK) is composed of the securities that make up the S&P MidCap 400. The two ETFs that track this index, including the SPDR MidCap 400 (MDY) and iShares S&P MidCap 400 Index Fund (IJH), are both up about 9.3% on the year; RWK has gained about 9.8%.
The RevenueShares Small Cap Fund (RWJ) is composed of the securities that make up the S&P SmallCap 600. The iShares S&P SmallCap 600 Index Fund (IJR), which tracks the cap-weighted index, is up about 9.3% so far in 2010, putting it nearly 300 basis points behind the similar RevenueShares fund.
RevenueShares has begun to catch the eye of ETF investors. The six funds offered by the firm now have nearly $400 million in assets (in addition to the three highlighted above, RevenueShares offers ETFs related to the S&P ADR Index, S&P 500 Financials Index, and Navellier Overall A-100 Index).
Disclosure: Author holds a long position in IVV