Risky Index Weighting Or This: ETF Outperforms

It was barely a year ago that Netflix (NFLX) was a middling mid-cap with a $5 billion market cap. After a near 300% gain last year, it’s suddenly in the land of the big boys with a market cap hovering around $20 billion that puts it in the top 40% of S&P 500 stocks screened and ranked by market cap.

Companies with $5 billion in market cap -- where Netflix was a year ago – are in the bottom 10% of the index.

That also means Netflix’s weight in standard index funds has risen as well, given that market cap is the default ranking mechanism for the S&P 500 index, and thus, its largest ETF tracker, the $174 billion SPDR S&P 500 (SPY). Granted, Netflix is an extreme example given last year’s turbo-charged price gain, but it is a glaring example of the problem of cap-weighted indexes in a rising market. If you own a fund or ETF tied to the S&P 500 you now own more Netflix -- with a trailing PE ratio above 250 -- than you did a year ago. Not exactly buy low, sell high.

Now seems like an especially timely juncture to look beyond simple market-cap weighted indexes. Given the relentless price rise of the past few years, those indexes now own a whole lot more of the pricier fare and less of the laggards. We can debate whether the market is overpriced or merely fairly priced until we’re all blue in the face, but that’s just choosing sides between worrisome and slightly-less-worrisome. A third option is to actively pursue a contrarian bent by seeking out value stocks to augment a portfolio that is currently riding solely on a (pricier) market-cap weighted approach.

Research Affiliates has been at the forefront of stepping away from market-cap weighted investing in favor of strategies that construct portfolios that rank holdings based on fundamental valuation, not size. More than $150 billion is riding on RA’s non-cap-weighted strategies, mostly institutional and pension money. About $2 billion has found its way to the retail ETF, PowerShares FTSE RAFI U.S. 1000 (PRF), which ferrets out large cap stocks Research Affiliates calculates are trading at the most compelling valuations. As seen in this chart, the ETF has outpaced the iShares Russell 1000 ETF (IWB), which is a market-cap weighted index of large caps.

PRF Total Return Price Chart

PRF Total Return Price data by YCharts

Moreover, according to Morningstar, the forward PE ratio for the market cap weighted iShares ETF is 16.2 compared to 14.6 for the PowerShares FTSE RAFI etf. (Full disclosure: Morningstar is an investor in YCharts.)

Research Affiliate’s fundamental approach focuses on four metrics: Current book value, and the 5-year averages for Cash Flow, Sales, and Dividend payments. If a company doesn’t pay a dividend it is ranked on the three remaining metrics.

While Apple (AAPL) is the largest holding in any market-cap weighted portfolio, it is pushed down to the 17th spot in the PowerShares portfolio. Google (GOOG), which is among the five largest holdings in the iShares Russell 1000 portfolio along with Apple, is only the 30th largest holding in the PowerShares FTSE RAFI 100 ETF, and its weighting is one-third the weight it holds in the market-cap weighted iShares portfolio. Microsoft (MSFT), another top-five position in any market-cap weighted portfolio is pushed down to the 13th spot in the PowerShares ETF.

As you should expect, the value bent for the PowerShares FTSE RAFI 1000 gives you a big helping of the still-healing financial sector. About one-fifth of the portfolio is invested in financials, five percentage points more than the weighting in the Russell 1000 index. Bank of America (BAC), JP Morgan Chase (JPM), Citigroup (C) and Wells Fargo (WFC) are among the 10 largest holdings in the portfolio. While the stock price for all four has rebounded sharply since the financial crisis, price-to-book value remains well below its pre-crash levels.

In terms of cash flow, the fact that this chart is basically unreadable is testament to the fact that price-to-cash flow remains low.

BAC Price to Free Cash Flow (TTM) Chart

BAC Price to Free Cash Flow (TTM) data by YCharts

You’ll also get a hefty serving of the big oil and gas stocks in this fundamentally-based ETF. Exxon Mobil (XOM) is the largest position in the portfolio, and Chevron (CVX) and Conoco Phillips (COP) are also in the top 10 holdings. Yes, they have all been laggards lately, as seen in a stock chart.

That’s a feature, not a bug. Yes, patience is required, as there’s no guarantee this is the year where the cyclical sector gathers some momentum. But if you’re looking for less-pricey large caps that are fundamentally strong, big energy is one sector where you can still buy low today. You can unleash financial advisor tools on any of these stocks.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.



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