Markets

Arnott’s PRF Is No Witchcraft

Bogle was responding to data showing the PowerShares FTSE RAFI US 1000 Portfolio (NYSEArca:PRF) that uses a fundamental index from Rob Arnott's Research Affiliates had almost twice the returns of the Vanguard S&P 500 Index Fund in the five-year period since the December 2005 launch of PRF.

Bogle, in a recent interview with Morningstar, was complaining about PRF's similarity to active management, and its higher costs, according to Bloomberg.

In the spirit of fairness, I thought I'd compare PRF with another ETF, the iShares Russell 1000 Index Fund (NYSEArca:IWB), which is a closer approximation of a capitalization-weighted version of PRF than an S&P 500 fund. PRF has collected about $1.2 billion since its launch, while IWB is a $6.67 billion fund.

Market-cap weighting represents the conventional means for selection and weighting of stocks in an index. Using this method, stocks with the largest market value receive the highest proportion in the index.

PRF's index takes a different approach, choosing and weighting stocks by four fundamental metrics:book value, cash flow, revenue and dividends.

However you want to characterize PRF's methodology, it's not witchcraft. PRF's index simply chooses a different path. It rejects the blunt instrument of market value in favor of firm-specific analysis. The RAFI index also takes the long view:Three of its four metrics are based on five-year averages.

Return And Risk

PRF had higher total return over the past three-year and five-year periods, though IWB has held the edge over the past year.

PRF return

The catch is that PRF took on higher risk than IWB to achieve higher returns over the three- and five-year sampling periods. PRF had higher beta over each period, at 1.09 and 1.08, respectively. The chart below shows beta intuitively. PRF's returns-the orange line in the chart below-dipped lower than IWB during the 2008-2009 market crash, but since then, has bounced higher in the subsequent recovery.

PRF vs. IWB

Alpha, a common measure of risk-adjusted outperformance, is
about as rare as witchcraft. While PRF shows higher returns over
three and five years, it fails to produce statistically significant
alpha for either period.

Alpha, a common measure of risk-adjusted outperformance, is about as rare as witchcraft. While PRF shows higher returns over three and five years, it fails to produce statistically significant alpha for either period.

Looking Ahead

The Bogle-inspired fuss over PRF sheds little light on how it might perform going forward. But we can get some inkling by looking at sector exposure relative to the cap-weighted proxy IWB. PRF significantly overweights financials and significantly underweights tech.

PRF Sector

PRF's sector tilts are neither intentional nor permanent, but
they do represent a meaningful departure from the cap-weighted
norm. A new set of tilts could come out of the fund's annual
rebalance.

PRF's sector tilts are neither intentional nor permanent, but they do represent a meaningful departure from the cap-weighted norm. A new set of tilts could come out of the fund's annual rebalance.

But radical change seems unlikely given the long-term nature of the methodology inputs. For better or worse, the five-year measuring periods on three of PRF's fundamental screens are slow to react to current conditions.

PRF's size and style biases are less pronounced than its sector tilts. The weighted-average market cap of its holdings is a bit smaller than IWB's. That said, PRF's portfolio composition is nothing like the small-cap bias that an equal-weighted indexing methodology would produce.

Price-to-earnings ratios for the two funds are comparable. Price-to-book shows a tilt toward value, but this ratio may just be a byproduct of the sector tilts. Financial stocks generally show lower P/B ratios than tech stocks. PRF's dividend yield, already a bit higher than IWB, may tick higher still as financials stocks edge toward more normal payout ratios.

PRF

The takeaway is that PRF is a viable choice for those inclined
to locate a bit higher on the risk/return curve.

The takeaway is that PRF is a viable choice for those inclined to locate a bit higher on the risk/return curve.

And fundamental methodology offers an intellectually appealing alternative to owning more of a stock just because its price goes up. Be mindful of the sector bets inherent in the choice though. Also, know that you'll pay more for the privilege. PRF's expense ratio is 0.39 percent to IWB's 0.15 percent.

Don't forget to check IndexUniverse.com's ETF Data section.

Copyright ® 2011 Index Publications LLC . All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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