Fundamental Sector Index ETFs

Fundamental Sector Index ETFs List
(click on symbol for data and articles)

PowerShares Fundamental Sector ETFs
PowerShares FTSE RAFI Basic Materials Sector Portfolio (PRFM)
PowerShares FTSE RAFI Consumer Goods Sector Portfolio (PRFG)
PowerShares FTSE RAFI Consumer Services Sector Portfolio (PRFS)
PowerShares FTSE RAFI Energy Sector Portfolio (PRFE)
PowerShares FTSE RAFI Financials Sector Portfolio (PRFF)
PowerShares FTSE RAFI Health Care Sector Portfolio (PRFH)
PowerShares FTSE RAFI Industrials Sector Portfolio (PRFN)
PowerShares FTSE RAFI Telecom & Technology Sector Portfolio (PRFQ)
PowerShares FTSE RAFI Utilities Sector Portfolio (PRFU)

What Are They?

• These ETFs track sectors, but with a twist: stocks are weighted according to a fundamental index. Fundamental indexes were pioneered by Rob Arnott. He argued that by giving greater weight to companies with larger market values, traditional indexes over-represent overvalued stocks, because the higher a stock's valuation the higher its market cap. He suggested an alternative: weight companies in an index based on fundamental factors other than market cap.
• The indexes that underlie the Fundamental Index ETFs weight stocks based on the following fundmental criteria: book value, cash flow, sales and dividends.
• Fundamental Index ETFs may be similar to Quant Strategy ETFs. The difference is that Quant Strategy ETFs may mix in techical factors, may not reveal the underlying rules to investors, and typically hold a limited number of stock. In contrast, Fundamental Index ETFs tend to hold all the stocks in an index, but ascribe different weightings to them based on fundamental criteria.

Why & How To Use Them

• There are three ways to use sector ETFs: (1) for short term trading, (2) to overweight one or a couple of sectors in a long term portfolio by adding a single sector ETF to a portfolio of broader ETFs, or (3) as the basic building blocks of a long term portfolio.
• The argument for using sector ETFs as the basic building blocks of a portfolio is that doing so makes your portfolio more granular, providing more rebalancing opportunities.
• Sector ETFs are attractive to short term traders and momentum investors, as there are dramatic differences in the performance of US sectors in most years.
• Use these ETFs instead of other sector index ETFs if you believe that fundamental indexes will outperform market cap weighted or equal cap weighted indexes. See Further Reading below.

What to Look Out For

• Compared to traditional index ETFs, specialty ETFs such as fundamental index ETFs tend to have higher expense ratios and wider buy-sell spreads (which makes them more costly to purchase and sell).
• A key advantage of ETFs based on market cap weighted indexes is that they do not have to buy or sell stocks due to fluctuations in stock prices, because changes in stock prices lead to changes in market cap. In contrast, ETFs based on non-market cap weighted indexes such as Fundamental Index ETFs have to buy and sell stocks as prices fluctate. That leads to higher portfolio turnover, resulting in potentially higher trading costs and lower tax efficiency.
• It's harder to build a diversified portfolio if you don't know which stocks your ETFs contain, as that opens the possibility of overlapping holdings between ETFs. Traditional market cap weighted index ETFs are easier to manage.

Further Reading

• The case for fundamental indexing is outlined in: Rob Arnott Discusses Fundamental Indexes, Robert Arnott on Market-Cap Weighted and Fundamental-Weighted Indexing, Rob Arnott and Fundamental Indexes Revisited, and Fundamental Indexing: New Ain't Necessarily Bad.
• The case against fundamental indexing is outlined in: Questioning Rob Arnott's Fundamental Index As An Investment Vehicle (Tom Coyne) and Rob Arnott's RAFI 1000 Fundamental Index -- Not An Index At All (Accidental Consultant),

• For more on PowerShares, see Mick Weinstein's PowerShares: Growing Assets But With High Expense Ratios.
• Types of sector ETFs: Global Sector ETFs, Foreign Sector ETFs, Primary US Sector ETFs, Equal Weight Sector ETFs, Quant Strategy Sector ETFs, Fundamental Sector ETFs and Leveraged Sector ETFs.

This page is part of The Seeking Alpha ETF Selector which sorts ETFs by type, highlights how to use them and what to look out for, and provides links to articles that discuss key issues for investors.