S&P Bullish on 2 Fundamentally-Weighted ETFs

Exchange traded funds that are weighted by constituents' market capitalization dominate the world of equity-based ETFs. These ETFs are easy to understand and, in many cases, cost effective.

That does not mean cap-weighted ETFs always offer the best returns and investors have increasingly sought alternatives to traditional cap-weighted fare.

Recent news from Invesco's IVZ PowerShares, the fourth-largest U.S. ETF sponsor, that its suite of fundamentally-weighted ETFs back by Research Affiliates indices crossed $5 billion in assets under management highlights the notion that investors are embracing new ways of thinking about ETFs.

Fundamental ETFs come with some advantages, as S&P Capital IQ points out.

"Unlike a mutual fund where management only reveals part of its strategy, the rules for these ETFs are known to investors, offering transparency. Further the re-weightings are periodic, offering investors a lower cost alternative than a mutual fund as is described below. These ETFs allow investors to add exposure to stocks based on characteristics that appeal most to them, rather than hold the whole market," said S&P Capital IQ in a new research note.

The research firm has an Overweight rating on the nearly $2.2 billion PowerShares FTSE RAFI US 1000 Portfolio PRF. PRF, which turns eight in December, tracks the FTSE RAFI US 1000 Index. That index ranks stocks based on book value, cash flow, sales and dividends.

PRF holds 1,018 stocks, not 1,000 has a direct competitor in the form of the iShares Russell 1000 ETF IWB. One of the knocks on fundamentally-weighted ETFs is that they are pricier than their cap-weighted peers. PRF's annual expense ratio is 0.39 percent, not alarmingly higher, but still well above the 0.15 percent charged by IWB. That means an ETF such as PRF must consistently outperform its cheaper rivals to win the battle for investors' dollars.

The data show PRF is winning. For the year-to-date period ending June 30, PRF's index was ahead of the Russell 1000 by nearly 300 basis points and over the past year, the margin was nearly 575 basis points, according to PowerShares data.

PRF's top sector weights are 22.4 percent to financial services and almost 12 percent to energy. Top-10 holdings include Exxon Mobil XOM, Bank of America BAC and Verizon VZ.

S&P Capital IQ also has an Overweight rating on the WisdomTree LargeCap Dividend Fund DLN. Unlike some of its rivals that focus on stocks' dividend increase streaks, DLN's "index is dividend weighted annually to reflect the proportionate share of the aggregate cash dividends each component company is projected to pay in the coming year."

There are times when DLN's methodology subjects investors to some lag relative to ETFs that focus on dividend increase streaks. For example, the SPDR S&P Dividend ETF SDY, which only includes stocks that have raised dividends for 25 consecutive years, is outpacing DLN this year.

However, over the past three years, DLN is ahead of SDY by 700 basis points. DLN is also slightly cheaper with an annual expense ratio of 0.28 percent compared to 0.35 percent for SDY.

DLN is diverse at the sector level with six groups – staples, technology, financials, health care, energy and industrials – receiving weights ranging from 15.4 percent at the top to 10.8 percent. Top-10 holdings include Exxon, AT&T T and Apple AAPL.

For more on ETFs, click here.