May 8, 2015

Is This the End of the Road for Fundamental ETFs?

End of the road for fundamental ETFs
Out of apparent boredom from cap-weighted index funds, alternative ETF weightings began picking up steam sometime in the mid-2000s. Many alternative weighting methodologies are pretty simple, equal weighting perhaps the most straightforward of all. And there's revenue, earnings, or dividends, among others.

For a time, "fundamental" ETFs seemed most promising of all. Instead of a more basic approach to portfolio weighting, these funds took a fundamental approach in an attempt to more accurately value each company based on some combination of factors, including those above plus book value, cash flow, and more. The main idea is that weighting by market cap is essentially inefficient and can vary widely from a company's intrinsic value. Tying weightings to fundamentals may instead be a better reflection of value, a better way to construct a fund, and may result is better returns.

Sounds great, right? Maybe, but somewhere along the line they may not have lived up to the hype since PowerShares recently announced it's discontinuing use of RAFI Fundamental indexes on many of its ETFs in favor of Russell Equal Weight and Pure Value/Growth indexes instead.

In additional to the PowerShares line of fundamental ETFs that had been based on the FTSE RAFI Indexes from Research Affiliates, Schwab's funds track the Russell Fundamental Index Series. Schwab's U.S. Fundamental Index ETFs for domestic and large international equities and have managed to gather between roughly $200 and $400 million each in assets with more modest AUM for international small cap and emerging markets variants.

Higher expenses are one of the first things that stand out to me in contrast with more garden variety cap weighted ETFs. PRF and PRFZ (the FTSE RAFI funds tracking large blend and small-mid blend market segments) each sport 0.39% expense ratios. That's not outrageous, but it puts these investments at an immediate disadvantage to the ultra low cost index funds charging half that, or as low as a quarter of that. Likewise with Schwab. The large cap variant, FNDX, charges 0.32%, but SCHX charges a paltry 0.04% in comparison!

So far, have the Schwab fundamental ETFs lived up to their goal of being a better mousetrap? They don't have a very long track record yet, but when we compare large and small cap funds against corresponding vanilla index ETFs, it appears to be a mixed bag so far.

Schwab Fundamental ETF Comparison: SCHX, FNDX, SCHA, FNDA

The core large cap ETF, SCHX, has slightly outperformed FNDX since fall of 2013. The reverse has held true for small caps (SCHA and FNDA). In both cases, you'll notice they track very closely to one another and exhibit a high degree of correlation.

What about international funds? As far as emerging markets go, FNDE and SCHE marched in lockstep until roughly the end of 2014, after which the fundamental version, FNDE, has fallen sharply behind SCHE. International developed market small caps funds exhibited the opposite behavior, with the fundamental version, FNDC, breaking away from SCHC by a few percent this year.

While there's nothing particularly wrong with fundamental ETFs, I have a hard time seeing any compelling reason to switch from core funds based on more conventional market-weighted indexes. This may change over longer periods of time, but even more established fundamental ETFs like PRFZ (the PowerShares FTSE RAFI US 1500 Small-Mid Portfolio) has correlated almost perfectly with IJH, one of the biggest S&P 400 ETFs, since late 2006. So all else being equal, I'm sticking with my low-cost index ETFs for now.

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