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PowerShares, one of the largest ETF issuers by assets, made the latest step in its push toward alternative index products on Thursday. The company converted seven existing products from its “Dynamic” ETF suite to Fundamental Pure Style ETFs that seek to replicate RAFI benchmarks. In addition the company will introduce two new ETFs, including the PowerShares Fundamental Pure Large Growth Portfolio (PXLG) based on the RAFI Fundamental Large Growth Index and the PowerShares Fundamental Pure Large Value Portfolio (PXLV) based on the RAFI Fundamental Large Value Index. The nine new ETFs will cover value, growth and blend strategies across three major market capitalizations, giving investors interested in the RAFI methodology an opportunity to finely tune U.S. equity market exposure:

Value Core Growth
Large Fundamental Pure Large Value Portfolio (PXLV) Fundamental Pure Large Core Portfolio (PXLC) Fundamental Pure Large Growth Portfolio (PXLG)
Mid Fundamental Pure Mid Value Portfolio (PXMV) Fundamental Pure Mid Core Portfolio (PXMC) Fundamental Pure Mid Growth Portfolio (PXMG)
Small Fundamental Pure Small Value Portfolio (PXSV) Fundamental Pure Small Core Portfolio (PXSC) Fundamental Pure Small Growth Portfolio (PXSG)

While PXLG and PXLV are new exchange-traded products, the other additions to the new RAFI suite were converted from equity ETFs that had previously sought to replicate Intellidex benchmarks. Those “intelligent” indexes utilized a proprietary quant-based methodology to determine holdings, seeking to identify companies from a broader universe (e.g., small-cap stocks) that maintained the greatest potential for capital appreciation. As such, the Intellidex products fall somewhere between true actively-managed ETFs and cap-weighted products. While they seek to replicate the performance of an index, the underlying benchmark strives to outperform broad-based equity markets.

PowerShares still maintains more than 25 “Dynamic” ETFs linked to Intellidexes, including the Dynamic Large Cap Growth Portfolio (PWB) and Dynamic Large Cap Value Portfolio (PWV). PWV has performed quite well relative to benchmarks such as the S&P 500 Value Index since its inception. PWB has delivered returns roughly in line with cap-weighted indexes.

RAFI Under the Microscope

While many of the largest equity ETFs are linked to market capitalization-weighted benchmarks, ETFs have facilitated an increase in interest in alternative weighting methodologies. Beyond weighting by dividends, earnings and revenues, one other technique that has grown in popularity in recent years is what is known as the Research Affiliates Fundamental Index (RAFI) methodology. Thanks to some impressive performances by funds linked to these benchmarks, interest in RAFI-weighted products has jumped in recent years. PowerShares was an early adopter of the RAFI products, already offering ETFs linked to RAFI weighted benchmarks focusing on Asia Pacific stocks (PAF), ex-U.S. developed markets (PXF) (PDN), emerging markets (PXH) and even junk bonds (PHB).

ProShares also offers a long/short ETF linked to an index that utilizes a unique spin on the RAFI methodology to establish a market neutral portfolio (RALS).

The idea behind the RAFI weighting methodology is relatively straightforward, and the actual process of determining holdings is simple as well. Whereas cap-weighted indexes generally determine components and individual allocations based on market capitalization (i.e., shares outstanding times price per share), the RAFI approach considers multiple fundamental factors to determine a stock’s weight in the index. Specifically, cash flow, book value, sales and dividends are used as inputs to determine the “RAFI weight,” effectively breaking the link between share price and weight within an index.

While cap weighting features a number of potential advantages - such as low maintenance - there are some noteworthy drawbacks as well. Cap-weighting has a tendency to overweight overvalued stocks and underweight undervalued ones, a bias that obviously has the potential to create a drag on returns. A look at the performance of various large-cap ETFs in 2010 highlights the impact of weighting methodologies on bottom line returns; SPY lagged behind many of the alternatives that employ alternative strategies for determining the weighting afforded to each component company.

“The idea behind a fundamental index was one of weighting companies according to their size in the economy,” Research Affiliates founder Rob Arnott told ETF Database in an interview earlier this year. “So that instead of looking at an index that looked like the composition and structure of the stock market, you would instead have a portfolio that looked like the composition and structure of the economy.”

The RAFI methodology has stirred up some controversy in recent weeks. Vanguard founder John Bogle described it as “witchcraft” in a recent interview, noting the higher fees and similarity to active management. That jab came as investors are beginning to take note of the impressive performance of the FTSE RAFI US 100 Portfolio (PRF) compared to the Vanguard 500 Index Fund.

Disclosure: No positions at time of writing.

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Source: PowerShares Launches 9 RAFI Style ETFs