S&P 500 index hit a new all-time high yesterday as investors shrugged off the worse-than-expected GDP revision. Yes, the economy contracted during the first quarter, but that was mainly due to brutal weather conditions and it now shows clear signs of picking up.
At current levels, stocks are not at all cheap but they are not too expensive either. Further the monetary policy is still accommodative, interest rates are very low and inflation remains subdued. All these factors are supportive for stocks.
On the flip side, earning growth has been missing and geopolitical risks remain high. As the Fed gradually withdraws its support, the broader market returns are likely to be lackluster this year. (Read: 3 Excellent Value ETFs Poised to Outperform )
Why Should You Focus on Fundamentals Now
The stock market had an incredible run last year as the massive surge of cheap money lifted all stocks, even in the face of modest economic growth and lackluster earnings. But as the QE fades away, investors now focus on company-specific fundamentals.
The rotation from growth stocks to value stocks and from small cap stocks to large cap ones clearly suggests that not all stocks will move in tandem with the broader market this year. Stocks with solid fundamentals will still be able to produce outsized returns, while overpriced stocks with not so great outlook will be punished by investors.
Academic research shows that fundamentally strong companies consistently deliver better risk adjusted returns than the broader market over long term. An easy solution is available to investors in the form of some of the ETFs that focus on such "fundamentally-strong" stocks. (Read: How Pure Strategies Crushed the Market )
Is Fundamental Weighting Better than Cap Weighting?
The ETF industry has traditionally been dominated by products based on market capitalization weighted indexes that provide a low-cost, convenient and transparent way of replicating market returns.
But capitalization weighted indexes are not the most efficient way of investing, as they give higher weights to bigger and often over-priced companies. Further as a stock rises in value, its weight in the index increases and when it falls, its weight in the index also comes down-somewhat similar to buying high and selling low-making these strategies inefficient. (Read: Volatility ETFs crash signaling further volatility )
Fundamental weighting selects and assigns weights to stocks based on their fundamental characteristics such as revenue, earnings, cash flow, dividends, buybacks and value.
PowerShares FTSE RAFI US 1000 Portfolio ( PRF )
PRF is based on RAFI index that aims to select stocks based on four fundamental measures viz, book value, cash flow, sales and dividends. The 1,000 equities with the highest fundamental strength are weighted by their fundamental scores.
Exxon Mobil, Chevron and AT&T are among the top holdings but the asset base is pretty well spread out, with top 10 holdings accounting for just 18% of the total.
The fund has about 38% allocation to large cap value stocks, followed by large cap blend stocks at 25%. In terms of sectors, financials, energy and information technology occupy the top three spots.
The product charges an expense ratio of 39 basis points. PRF has returned 150.4% in the last five years compared with 129.3% for SPDR S&P 500 ETF (SPY).
Schwab Fundamental U.S. Large Company Index ETF ( FNDX )
Like PRF, FNDX also follows RAFI methodology. But unlike the earlier series of RAFI indexes, Russell Fundamental U.S. Large Company Index focuses on three fundamental measures: retained operating cash flow, adjusted sales, and dividends plus buybacks..
The product has highest allocation to energy, information technology and financial sectors while Exxon Mobil, Chevron and Conoco Philips are the top three holdings.
With an expense ratio of 32 basis points, this ETF is slightly cheaper than PRF.
As FNDX was launched in August 2013, not much of fund performance history is available though it has been beating the market cap weighted index since inception.
Per Schwab, back-tested data for the period August 1996−December 2012, shows that the fundamental index strategy could have substantially outperformed traditional index investing, returning 10.1% per year versus 7.2% for the cap weighted index, with a slightly lower volatility.
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PWRSH-FTSE RAFI (PRF): ETF Research Reports
SCHWAB-F US LCI (FNDX): ETF Research Reports
SPDR-SP 500 TR (SPY): ETF Research Reports
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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.
