Innovative ETFs: PowerShares FTSE RAFI UK 100

An explanation and real-life example to show how fundamental indexing operates

Alastair Kellett 11 May, 2012 | 3:40PM

This article is part of our Innovative ETFs series, where we will discuss exchange-traded products (ETPs) that are seen as innovative—either they use a newly-invented strategy or process to track their index, or they attempt to improve upon existing strategies. Conventional investing wisdom states that you shouldn’t invest in anything you don’t understand. In fact, many say that if you can’t understand it within 5 minutes then it’s probably not for you. Our intention here is to break down the specifics of these innovative ETFs, leaving you with a better understanding of their potential benefits and risks. If at the end of this article you’re still not clear on how this ETF works or whether it’s suitable for your portfolio, then it’s probably not right for you.

Understanding Fundamental Indexing
This article will explain fundamental indexing and drill down into some of the specific characteristics of the PowerShares FTSE RAFI UK 100 (PSRU). This ETF is one of a series of UK-listed ETFs that tracks “fundamental” indices offered by PowerShares.

Fundamental indexing means using accounting measures, rather than other more conventional metrics such as market capitalisation, to size the constituents of an index. It represents something of a middle ground between active and passive investment. It is passive in the sense that it is a rigid, rules-driven approach to constructing a broad basket of securities, but in so doing it aims to outperform its capitalisation-weighted counterparts. The key advantage of fundamental indexing is that it avoids the capitalisation-weighted methodology’s tendency to put more weight on already overvalued securities. But there are shortcomings to fundamental indexing, too; while it doesn’t get as taken in by overhyped market darlings, it also overlooks information about how the market views a company’s growth prospects. Also, it often takes on different types of risk, over-representing value stocks and less liquid names.

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Alastair Kellett

Alastair Kellett  is an ETF analyst with Morningstar Europe.

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