Investors can diversify their core equity positions with smart-beta exchange traded funds that have outperformed traditional market capitalization-weighted indices and provide an alternative indexing methodology.
In comparison, the Russell 1000 Index, which tracks 1,000 of the largest U.S. securities based on market cap, has gained 7.3% year-to-date and returned an average 19.3% over the past five-years.
"Market-cap-weighted indexes tend to overweight expensive stocks and underweight cheaper ones," according to Morningstar analyst Alex Bryan. "PowerShares FTSE RAFI US 1000 PRF seeks to address this potential problem while retaining the benefits of a traditional index fund. It weights its holdings according to fundamental measures of size, including book value, cash flow, sales, and dividends, rather than market cap."
Due to PRF's indexing methodology, the ETF tends to skew toward value stocks. Looking at the fund's market capitalization and style allocations, large-cap value makes up 38.0% of PRF, followed by large-cap blend 26.3%, large-cap growth 12.8%, mid-cap value 9.6%, mid-cap blend 6.1% and mid-cap growth 2.6%.
"Unlike traditional value index funds, this fund does not restrict its holdings to one segment of the Morningstar Style Box, which may improve diversification," Bryan added. "It also trims its exposure to stocks whose valuations expand relative to their peers and increases exposure to those whose valuations compress when it rebalances."
Over the past five years, PRF has also outperformed a value-focused Russell 1000 ETF, the iShares Russell 1000 Value ETF (NYIWD), which advanced an average 18.8%. Value investments have been an attractive play this year as investors shied away from growth sectors and shifted into value picks. IWD is up 9.1% year-to-date.
Smart-beta, fundamental index-based ETFs, though, are not constricted to value stocks nor do they ignore growth stocks. The fund tracks a type of actively managed style that bolsters positions that become cheap and pares back positions as they become expensive.
"This contra-trading approach (buying on weakness and selling on strength) may help the fund more effectively profit from potential market mispricing than cap-weighted value funds," Bryan said.
While PRFs can capture reversion associated with the value effect and potentially generate greater returns, the ETF also experiences greater volatility than the Russell 1000 index.
"This is a suitable core holding for long-term investors who can stomach a little extra volatility to profit from potential market mispricings, or a value risk premium," Bryan said.
Max Chen contributed to this article.
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