Fundamental ETFs Go Beyond Index Investing

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

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How fundamental ETFs stack up. Not surprisingly, fundamental ETFs tend to do well when the market favors the metric on which their weightings are based. "Every factor will have its day," says James Early, advisor of the Motley Fool Income Investor newsletter and a former hedge fund analyst. "We could be in a dividend market, in which case you would want a dividend-weighted ETF. We could be in an earnings market where the market is just favoring fast earnings growth in which case an earnings-weighted ETF would be good."

But it really comes down to diversification, Early says, and that means having some market-cap weighted ETFs in your portfolio as well. "In a momentum market, cap-weighting is going to win," he says. "If we are in a kind of raging bull market, you want to be in a cap-weighted ETF because the faster growing stuff is just going to naturally assume a larger portion of your portfolio."

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That's all well and good if the "faster growing stuff" continues to grow, but once it slows down, you'll be glad you have fundamental ETFs on your side. "You might then want an equal-weighted or dividend-weighted ETF because that's going to protect you," Early says. "You won't be so heavily weighted into the rising stars that may end up falling."

The drawbacks. Along with the advantages of fundamental ETFs, there are some drawbacks of which investors should be aware. Fundamental ETFs tend to be more expensive to own than regular ETFs, but, as with most ETFS, they still cost much less than the average mutual fund. "You've really got to get the expense ratio low and that could be an issue with some of these ETFs," Early says. "I like expense ratios under 0.4 percent."

Fundamental ETFs that Early recommends include WisdomTree's Large-Cap Dividend fund (symbol DLN) with an expense ratio of 0.28 percent and Rydex's equally-weighted S&P ETF (RSP), which butts up against his max expense ratio of 0.4 percent.

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Investors can expect to see these types of ETFs underperform in markets where overheated sentiment gets ahead of fundamentals. "In a bubble we would lag, but when the bubble bursts we'll get back all that underperformance and then some," O'Hara says. "In a huge market sell-off, again, we might lag, but when we rebalance we'll pick all that back up. It's kind of cyclical because people's emotions are cyclical."

While many fundamental ETFs have posted impressive numbers since their inception five or six years ago, cautious investors and financial analysts still have questions about the long-term sustainability and performance of these products, especially given their structural divergence from that central tenet of index investing - that markets really are efficient. "It's a challenge to what is deemed to be conventional wisdom rooted in a history that perhaps is not valid anymore," O'Hara says. This newer type of fund remains a small piece of the overall ETF market, but the category's solid performance and cost efficiency are starting to make fundamental ETFs more and more attractive to investors.