Fundamental ETFs Go Beyond Index Investing

An unconventional twist on ETF investing weights companies based on fundamentals, not market cap.

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Although exchange-traded funds track everything from the S&P 500 to an ultra-specific index made up of companies that support NASCAR's Sprint Cup Series, they all generally work the same. They mirror the holdings of an index, keep costs and turnover low, and aim to at least match the benchmark.

But even that age-old indexing formula is changing at some ETF firms, which are altering the recipe by which stocks are weighted in an index. Instead of following the conventional method of weighting companies based on market capitalization, so-called fundamental ETFs weight companies based on financial metrics such as revenue, dividends, and cash flow. The idea is to break the link between a stock's price and its weight on an index, which can help insulate investors from wild swings in the market. U.S. News talked with some experts about how these ETFs work and what role they could play your portfolio.

How fundamental ETFs work. Firms that offer fundamental ETFs weight funds based on a specific metric or combination of metrics, such as revenue, dividends, earnings, sales, or cash flow. They re-evaluate the rankings and weighting of fund holdings on an annual basis and rebalance the fund as needed to account for any changes in the market. For example, fundamental ETF purveyor RevenueShares weights funds based on revenue. "We take the S&P 500 or 400 or 600 and once per year, we calculate each constituent's stock's revenue," says Sean O'Hara, president of RevenueShares. "Then we give [a company] its representative weight based on its revenue." O'Hara favors this method because revenue is something all companies report and, over time, he says funds weighted by revenue tend to be less volatile than their market cap-weighted counterparts.

Another fund firm, WisdomTree, bases some of its fundamental ETFs on dividends. "Dividends are the most intuitive measure of value," says Jeremy Schwartz, WisdomTree's Director of Research. "From basic finance 101, you learn that assets are tied to their cash flows and for stocks, cash flows are dividends. So theoretically, dividends are a very important factor."

Investment firm Research Affiliates created another approach to fundamental indexing, which involves using multiple measures of a company to determine weighting structures. The company developed a series of indexes in conjunction with The Financial Times and the London Stock Exchange (FTSE), which incorporates sales, cash flow, dividends, and book value. "The idea was to have a combination of these four fundamental factors that would smooth out any of the individual issues [associated with] using just one fundamental factor," says Ed McRedmond, senior vice president of institutional and portfolio strategies at Invesco PowerShares. Invesco's PowerShares group partnered with Research Affiliates in 2003 to offer a line of ETFs linked to FTSE RAFI indexes.

[See ETFs for Beginning Investors.]

Why it matters. Fundamental ETFs essentially break the link between stock price and portfolio weight, which helps equalize major swings in the market. "We're trying to judge price movements relative to some measure of value," says Schwartz. "It's a way to protect yourself from bubbles."

Most experts and even proponents of fundamental ETFs don't deny that over the long term, the market is fairly efficient in pricing things correctly. However, over the short term, market cap-weighted funds can be more susceptible to bubbles and crashes because they give the highest-priced stocks the largest weighting and the lowest-priced stocks the smallest weighting. As a result, market cap-weighted funds tend to overweight overvalued stocks and underweight undervalued stocks.

"When stocks double in price, for instance, a market cap-weighted index will just hold twice as much weight of that stock," Schwartz says. "They never say, 'Should I hold twice as much of this stock?' They're simply following the market trend."

However, by rebalancing fundamental ETFs on a yearly basis, investors can actually convert the market's short-term inefficiencies into a benefit. "Over a 10-year period, the market probably does have an efficient pricing mechanism built into it," O'Hara says. "But for a week or so it might not be [priced correctly], even for a year or longer it might not be. So by rebalancing, we take advantage of that short-term inefficiency."