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Fundamentally Weighted ETF’s

We are constantly on the lookout for ways to both diversify our portfolios, while simultaneously improving the risk adjusted return. ETF’s have many advantages over traditional mutual funds, e.g. the ability to trade interday, no early redemption fees, low cost structures, and are not typically tied to the track record of an individual fund manager. This last advantage is a result of the fact that ETF’s are typically set up to track some type of passive index, limiting the ability of a fund manager to add (or subtract) value with his stock picking abilities.

However, there are many studies that indicate that there is a sustainable advantage to be had by picking stocks based on some fundamental factors like company size, dividend yield, cash flow, etc. A fixed index holding does nothing to capture that value.

Most ETF’s reflect a major index, and further they weight the stocks in the index by their market capitalization (e.g. the total value of all outstanding shares of the company.)

There are studies that would suggest that a capitalization weighting on an index is flawed by design. The basic reasoning: at any time there are going to be some stocks that are overvalued and some that are undervalued. Assume that after some time they will regress to their true value, or at a minimum the valuation errors are redistributed ( a different set of stocks are over/ under valued). It then follows that the stocks that are overvalued in a capitalization weighted index will be weighted more heavily than those that are undervalued, and so over the long run such an index will underperform.

To counter this perceived weakness of traditional index fund investing, recently a few companies have introduced “enhanced” ETF’s that try to exploit some of the historically fundamental tools to add value to their exhange traded fund offerings.

WisdomTree ETFs

WisdomTree ETFs are one of the simpler ones to understand. The WisdomTree family of exchange traded funds attempts to expliot some of the research of Jeremy Seigel, and in fact the “Wizard of Wharton” sits on their board. You may recall him as the author of “Stocks for the Long Run” and “The Future for Investors“. The basic approach of the WisdomTree funds is to weight the indices by dividend yield instead of market capitalization. There is a fair amount of information on their web site on backtesting of this approach, but a couple of examples would suggest that for the period 1980 to 2005, the large cap fund would have outperformed the S&P 500 by a little over 1% per year, but for the small cap fund the improvement in total return was almost 5% per year over the Russell 2000 index, which is quite impressive.

One of the issues with these funds is of course the fact that as a fund of funds, there are two layers of fees that you are paying, the fees on the original fund, and the fees to the Fundx management team.

PowerShares ETFs

Another company that offers “enhanced” ETF’s is PowerShares. They have quite a variety of offerings. A couple of them track the Valueline timeliness ratings, which have a long history of real time performance that beats the market, and has been tracked by the Hulbert Financial Digest for a couple of decades. Some of the other offerings include the Dynamic Market Intellidex Index, which attempts to capture several fundamental factors in the stock weighting process, All of these have impressive results in backtesting, but I’m not clear on what kind of real time results could be suggested (unlike the ValueLine ratings.)

Filed under ETF News

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