Innovative ETPs: Powershares FTSE RAFI UK 100

Fundamental indexing represents something of a middle ground between active and passive investment

Alastair Kellett 31 May, 2012 | 3:39PM

This piece is one in a sub-series of articles examining the broad category of “advanced beta” indices and the exchange traded products (ETPs) that track them. In the first, we focused on the general risks and opportunities presented by “advanced beta” strategies, and in this one we will drill down to look at some of the specific characteristics of the PowerShares FTSE RAFI UK 100 (PSRU), one of a series of UK-listed ETFs to track “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 does aim 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.

PowerShares offers a number of UK-listed ETFs referencing FTSE RAFI indices conceived by fundamental indexing firm Research Affiliates. The indices are constructed by attaching a fundamental value to all the securities within a particular market. These scores are based on each company’s revenue, cash flows, dividends, and book value. The first three metrics are based on an average level over the last five years. Stocks are then ranked by their fundamental value, and the highest scoring ones are selected for the index. Each stock’s weight in the index is proportional to its fundamental score so that the largest companies, as measured in those accounting terms, are given the biggest weight. The scores are recalculated and the index rebalanced on an annual basis. In many of the indices, individual security weights are capped quarterly at 10%.

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About Author

Alastair Kellett

Alastair Kellett  is an ETF analyst with Morningstar Europe.

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