Tuesday 16 March 2010

Comparing Fundamental and Equal Weight Index ETFs - and the Winner is ...

Last week I posted about the very enticing results of academic research that found significant and sustained out-performance by both fundamental and equal weight indices compared to the cap-weighted index method that has been the basis of choice for passive index investors for decades.

But indices are only a theoretical construct, the proof in the pudding for the investor is whether the practical challenges of operating a fund to track the index - trading costs from reconstitution (buying and selling as companies enter or leave the index) and rebalancing, management expenses, bid-ask spreads, tax costs (e.g. if too much capital gains get distributed causing taxes to be payable) - eat up the return differential and leave the investor no better off. A second major question is whether the out-performance persists in the time after the research data ended (so-called out of sample performance) and whether it does on a risk-adjusted basis.

Comparison Table
I've compared the original cap-weighted leader, the SPDR S&P 500 ETF (symbol SPY), against these US-traded ETFs which mimic the promising index candidates I named in my first post:
Key criteria where an ETF has the best number are highlighted in green.

My Conclusions
  • Winners - PRF and RSP - both these funds have outperformed SPY by a significant margin in the last three years - by 1.3 to 1.8%; that is exactly what we hoped to see in the out-of-sample period after 2006. Both have also outperformed on a risk-adjusted basis as the higher Sharpe ratio (it's less negative) shows. Both have total extra expenses (Expense Ratio of about 0.3% extra plus Tracking Error vs its own index of 0.4% to 0.7%) that add up to less than the extra return. Recall that the academic study found longer term index annual out-performance of almost 2% so if the extra cost for these two ETFs stays below 1% per year, the investor will be better off net by about 1% a year. That's pretty darn good. Other measures like bid-ask spread, potential capital gains exposure and tax cost do not alter this conclusion, and perhaps favour PRF and RSP even more. Of course, it all could still be a flash in the pan and RSP and PRF could under-perform forever from now on, or next month or next year. More likely is that another bubble will come along when the over-valued stocks will leap ahead for a number of years, as happened during the 1990s, and then RSP and PRF will under-perform for years.
  • Jury is Still Out on PWC and DHS - 3-year returns and Sharpe ratios are both quite a bit worse than SPY's. Maybe this is just a temporary period and the two funds will shoot ahead but no one knows. The funds' costs are in line so it is the actual portfolio that has caused the performance difference. The high proportion of assets (30% and 45% respectively) in the top ten holdings of each makes clear that the ETFs' results depend heavily on a few companies only. It's something that makes me as a passive index investor nervous.
Implications for a Portfolio
  • Replace SPY and "Value" ETFs with either or both PRF and RSP - as the academic studies showed and the RAFI index creators say themselves, RSP and PRF have an inherent value tilt. Though strictly speaking all the funds are considered Large Cap, they could replace Total Market ETFs for someone who doesn't want to own lots of funds. Invesco Powershares does offer a small-mid-cap fund (PRFZ) and it might be a good combination, though I haven't looked at it detail.
  • The Fundamental Index (as in RAFI, which is trademarked by the creators at Research Affiliates) claims that it works by systematically putting less weight on over-valued stocks and more weight on under-valued stocks. It that is so then it will produce superior risk-adjusted returns in other countries and markets like Canada, Europe, Japan etc. The RAFI folks say they have looked at data for other places and the principle pans out. If that's true, then goodbye any and all Value funds.
I have not compared the ETFs (from Claymore Canada) and mutual funds (from Pro-Financial and Invesco Trimark) available in Canada that are also SPY replacement candidates using RAFI fundamental index tracking. That comparison will be fodder for another post. No funds like RSP exist in Canada, so far as I know, to track the S&P 500 equal weight index.


The Personal Finance Blog said...

This is a very interesting conclusion. It certainly is a departure from "conventional wisdom". Goes to show that nothing is set in stone in the investing world.

Brian said...

With only 3 years worth of data for "after operational expenses" its almost impossible to make a judgement if this outperformance will last. But I think the theoretical back testing does show that fundamental indexes do indeed outperform.

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