The Invesco FTSE RAFI US 1000 ETF (NYSEARCA:PRF) was the first fundamentally weighted ETF. The RAFI in PRF’s name refers to the “Research Affiliates Fundamental Index”. RAFI claims to perform (usually) better than value when value outperforms and when value underperforms. Is this really the case? And even more importantly: is RAFI outperforming the stock market in general? The results are mixed. PRF is outperforming value, but it has itself a value tilt that acts as a drag on its performance.
Smart beta
Academic research has discovered many so-called anomalies: investment strategies that perform better than could be expected given their market beta. The most well-known anomalies are value and momentum. Others are e.g., the small-cap or size-effect, low volatility, and quality.
Such strategies are outperforming market cap weighted indices (they create alpha), but the implementation happens typically rules-based and systematic. The performance is hence beta-like: you are rewarded for your exposure to a certain anomaly or factor. Tower Watson solved the mix between alpha and beta by coining the term “smart beta” in 2007.
Smart beta also encompasses the so-called fundamental indexing or weighting. Contrary to traditional market indices like the S&P 500 that use market cap weighting, fundamental weighting determines portfolio weights based on (fundamental) factors like sales, earnings, dividends, or book value.
The first fundamentally weighted index was created by Research Affiliates, headed by Rob Arnott, and was called the “Research Affiliates Fundamental Index”, or RAFI.
RAFI weights companies according to their macroeconomic size, rather than their market capitalization. While a traditional stock market index tracks the composition of the stock market, a fundamental index rather tracks the composition of the (publicly traded) macroeconomy. This macroeconomy is dominated by big value companies while the cap-weighted stock market is rather dominated by expensive growth companies. As a result, RAFI has a value tilt compared to traditional market indices.
Returns-based style analysis by Portfolio Visualizer shows indeed that PRF has a strong large cap value tilt compared to the iShares Russell 1000 ETF (IWB). The value tilt is however lower than the one of the iShares Russell 1000 Value ETF (IWD).
Figure 1: Returns-based style analysis (Portfolio visualizer)
Returns-based style analysis aims to explain the portfolio returns based on asset class exposures, it does not identify the actual portfolio holdings.
RAFI performance
RAFI claims to outperform the stock market in general and to outperform value stocks and to do the latter both when value stocks perform and don’t perform:
RAFI usually beats value when value is winning and when value is losing!
Figure 2: Performance (Research Affiliates)
The green line in Figure 2 shows that the fundamental index indeed consistently outperforms value. The red line shows the performance of value compared to the traditional market cap weighted index: value is underperforming. During the value crash RAFI was underperforming the traditional index (due to its value-tilt), but did (continue to) outperform value.
Also, the past 12 months large cap growth was certainly outperforming large cap value.
Figure 3: Total return chart (Radar Insights)
The result: RAFI is underperforming the traditional stock market indices and outperforming the value indices.
Figure 4: Total return chart (Radar Insights)
The longer-term performance confirms this picture. The Invesco FTSE RAFI US 1000 ETF, the first fundamentally weighted ETF, was launched in December 2005. PRF clearly outperforms the value ETF IWD, but it’s not outperforming the “traditional” IWB.
Figure 5: Risk and return (Portfolio visualizer)
Invesco FTSE RAFI US 1000 ETF
The Invesco FTSE RAFI US 1000 ETF is based on the FTSE RAFI US 1000 Index. As a real smart beta ETF, PRF operates as an index fund and is not actively managed, meaning that it does not seek to outperform its benchmark. The index is designed to track the performance of the largest US equities, by calculating an overall weight (a “fundamental value”) for each security by equally weighting each of the following four fundamental measures:
- Book value as of the review date;
- Cash flow averaged over the prior five years;
- Sales averaged over the prior five years; and
- Total dividend distributions averaged over the prior five years.
The 1,000 equities with the highest fundamental strength are weighted by their fundamental scores. The Fund and the Index are reconstituted annually. The expense ratio is 0.39% and the ETF has a dividend yield of 2%. This compares to a dividend yield of 1.4% for IWB and 2.2% for IWD.
Also on the P/E level is PRF (19) more value than IWB (21) but less value than IWD (15).
The top 10 holdings of the fund can be found in the below table.
Figure 6: Top 10 holdings (Invesco)
The biggest sectors in the fund are Financials, Technology and Healthcare.
Figure 7: Sector allocation (Invesco)
Compared to IWB, PRF is overweight Financials and Energy and underweight Technology.
Figure 8: Sector drift (ETF Research Centre)
Given the nice performance of Technology (compared to Energy and certainly Financials) it comes as no surprise that PRF is underperforming IWB.
Figure 9: Total return chart (Radar Insights)
What can we expect going forward?
Outlook
Based on the trends for equity factors, style-boxes and sectors we are sceptical about PRF’s ability to outperform IWB going forward. On the other hand we expect PRF to continue to outperform the value ETF IWD.
Growth, Quality and Multifactor are in a long-term uptrend, while Value is in a long-term downtrend.
Figure 10: Trends (Radar Insights)
We get the same picture when we look at style boxes: The trend is also better for Growth compared to Value in general and in particular among large caps.
Figure 11: Trends (Radar Insights)
The trend for Technology is also calling for a continued outperformance of IWB compared to PRF.
Figure 12: Trends (Radar Insights)
In comparison with IWD is PRF overweight the sectors in a long-term uptrend like Technology, Consumer Discretionary and Communication Services.
Figure 13: Sector drift (ETF Research Centre)
Figure 14 sums it up nicely: we expect PRF to continue to outperform the value ETF IWD but also to continue to underperform IWB.
Figure 14: Trends (Radar Insights)
Conclusion
The Invesco FTSE RAFI US 1000 ETF was the first fundamentally weighted ETF. PRF has by construction a value tilt, and this tilt acts like a break on PRF’s performance compared to traditional market cap weighted equity indices. Since its inception at the end of 2005 PRF is clearly outperforming value ETFs, but it slightly underperforms traditional ETFs like IWB.
Based on the trends for equity factors, style-boxes and sectors we are sceptical about PRF’s ability to outperform IWB going forward. On the other hand we expect PRF to continue to outperform the value ETF IWD.
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