Fundamental ETFs Throw their Weights Around

Most ETFs and mutual funds weight companies they hold by market capitalization. The market's collective judgment of the worth of each security, however, is not the only way to weight holdings, and it may not be the best. A growing number of ETFs use fundamental financial measures such as revenue, price/earnings, earnings growth or dividend yield.Over one hundred fundamental ETFs now cover every conceivable asset class and are often referred to as active, intelligent, or dynamic. Claims of inherent superiority are made because of impressive historical performance of stocks meeting showing high scores on various fundamental measures. But ETFs which use these measures need the extra edge over standard funds because they demand more in fees.Two funds from PowerShares, however, sharpen their pencils and are the default choices for basic placement in this asset class:

• PowerShares FTSE RAFI US 1000 Portfolio ETF (NYSEArca:PRF - News), annual fees: 0.39%
• PowerShares FTSE RAFI US 1500 Small-Mid Portfolio ETF (NYSEArca:PRFZ - News), annual fees: 0.39%

PRF contains the largest 1000 stocks and PRFZ the next 1500 smaller firms. Buy them together in 80%/20% amounts and you approximate the total market. It is a benefit that FTSE, the well-regarded British index provider, creates a target universe of 1000 large company stocks and avoids the logjam created by S&P at the 500 stock mark. RAFI is a pioneer in fundamental modeling and manages the actual stock selection by fundamental criteria from the target universe. They disclose the ratios used but not how the ratios are combined. The system is a black box, totally proprietary.Another moderate cost line from RevenueShares simply weights holdings by revenues. This tends to favor stable value firms in mature industries, not pricier high-growth firms. Benefits include generally low turnover and volatility, a transparent index methodology for choosing stocks, and relatively moderate fees:

• RevenueShares ADR ETF (NYSEArca:RTR - News), annual fees: 0.49%
• RevenueShares Financials Sector ETF (NYSEArca:RWW - News), annual fees: 0.49%
• RevenueShares Large Cap ETF (NYSEArca:RWL - News), annual fees: 0.54%
• RevenueShares Mid Cap ETF (NYSEArca:RWK - News), annual fees: 0.54%
• RevenueShares Navellier Overall A-100 ETF (NYSEArca:RWV - News), annual fees: 0.6%
• RevenueShares Small Cap ETF (NYSEArca:RWJ - News), annual fees: 0.54%

These have shown strong performance in back testing compared to market cap equivalent funds dating to 1979, according to RevenueShares. Standard & Poor's verified results back to 1991.The typical Fundamental ETF is more like PowerShares' PRF. It will select a target universe of stocks, score each company in the universe on a combination of financial ratios (such as P/Es), filter out poor scoring companies, and buy high-scoring firms. Generally the ratios are disclosed but details of how they are combined are kept secret.While on their face fundamental weighting schemes seem entirely mathematical, they are designed to exploit the psychology of investors. Researchers say investors tend to overbuy stocks in favor with analysts and the media and to oversell stocks out of favor. In First Trust's Alphadex line, for instance, "a value model is applied to exploit the tendency of investors to extrapolate past results and a growth model is applied to take advantage of the tendency for investors to under-react to new information." The Alphadex value model uses book value-to-price, cash flow-to-price ratios and return on assets. The growth model uses momentum of price appreciation over three, six and 12 months, one-year sales growth rate and sales-to-price ratio. Both models can be used simultaneously in a single fund.Although historical returns convince us that fundamental ETFs have an edge to exploit, long periods of superior past performance is no guarantee of future behavior. Historical stock analysis is full of examples of previously successful strategies which bombed the minute they were declared long-term winners. (The vaunted value premium is a famous example, and its existence and exploitability is still a matter of academic debate). Successful strategies sow the seeds of their own decline, because the more assets they attract, the more they will crowd out their own profitability.We are convinced that fundamental financial ratios can improve absolute returns, especially in these times of whipsawing investor sentiment. But this edge, if it exists, will be reduced by excess fees fundamental ETFs charge over plain vanilla ETFs. Fundamental ETFs must outperform by 0.2% to 0.6% more per year to recoup higher fees before they begin to benefit investors. While many fundamental ETFs may show lengthy runs of superiority topping 1% per year, we think it prudent to be skeptical that performance can exceed 1% on a sustained basis. Admittedly this is a crude rule of thumb, but there is room for extra profit.Large company and broad-market fundamental ETFs include:

• PowerShares Active Mega Cap ETF (NYSEArca:PMA - News), annual fees: 0.75%
• PowerShares Active Alpha Multi-Cap ETF (NYSEArca:PQZ - News), annual fees: 0.75%

Various offerings address small and mid-cap asset classes:

• First Trust Mid Cap Core AlphaDEX ETF (NYSEArca:FNX - News), annual fees: 0.7%
• PowerShares Dynamic Small Cap Portfolio ETF (AMEX:PJM - News), annual fees: 0.6%
• PowerShares Dynamic Mid Cap Portfolio ETF (AMEX:PJG - News), annual fees: 0.6%
• First Trust Small Cap Core AlphaDEX ETF (NYSEArca:FYX - News), annual fees: 0.7%

Other ETFs slice and dice the market both by company size and growth vs. value characteristics:

• First Trust Large Cap Core AlphaDEX ETF (NYSEArca:FEX - News), fees: 0.7%
• First Trust Large Cap Growth Opportunities AlphaDEX ETF (NYSEArca:FTC - News), annual fees: 0.7%
• First Trust Large Cap Value Opportunities AlphaDEX ETF (NYSEArca:FTA - News), annual fees: 0.7%
• First Trust Multi Cap Growth AlphaDEX ETF (NYSEArca:FAD - News), annual fees: 0.7%
• First Trust Multi Cap Value AlphaDEX ETF (NYSEArca:FAB - News), annual fees: 0.7%
• PowerShares Dynamic Large Cap Value ETF (AMEX:PWV - News), annual fees: 0.6%
• PowerShares Dynamic Mid Cap Growth Portfolio ETF (AMEX:PWJ - News), annual fees: 0.6%
• PowerShares Dynamic Mid Cap Value Portfolio ETF (AMEX:PWP - News), annual fees: 0.6%
• PowerShares Dynamic Small Cap Growth ETF (AMEX:PWT - News), annual fees: 0.6%
• PowerShares Dynamic Small Cap Value ETF (AMEX:PWY - News), annual fees: 0.6%

For sector investors there are numerous offerings:

• First Trust Utilities AlphaDEX ETF (NYSEArca:FXU - News), annual fees: 0.7%
• PowerShares Dynamic Banking Portfolio ETF (AMEX:PJB - News), annual fees: 0.6%
• PowerShares Dynamic Basic Materials Sector Portfolio ETF (AMEX:PYZ - News), annual fees: 0.6%
• PowerShares Dynamic Biotechnology & Genome ETF (AMEX:PBE - News), annual fees: 0.6%
• PowerShares Dynamic Building & Construction Portfolio ETF (AMEX:PKB - News), annual fees: 0.6%
• PowerShares Dynamic Consumer Discretionary Sector Portfolio ETF (AMEX:PEZ - News), annual fees: 0.6%
• PowerShares Dynamic Consumer Staples Sector Portfolio ETF (AMEX:PSL - News), annual fees: 0.6%
• PowerShares Dynamic Energy Exploration & Production Portfolio ETF (AMEX:PXE - News), annual fees: 0.6%
• PowerShares Dynamic Energy Sector Portfolio ETF (AMEX:PXI - News), annual fees: 0.6%
• PowerShares Dynamic Financials Sector Portfolio ETF (AMEX:PFI - News), annual fees: 0.6%
• PowerShares Dynamic Food & Beverage Portfolio ETF (AMEX:PBJ - News), annual fees: 0.6%
• PowerShares Dynamic Healthcare Sector Portfolio ETF (AMEX:PTH - News), annual fees: 0.6%
• PowerShares Dynamic Industrials Sector Portfolio ETF (AMEX:PRN - News), annual fees: 0.6%
• PowerShares Dynamic Insurance Portfolio ETF (AMEX:PIC - News), annual fees: 0.6%
• PowerShares Dynamic Leisure & Entertainment Portfolio ETF (AMEX:PEJ - News), annual fees: 0.6%
• PowerShares Dynamic Media Portfolio ETF (AMEX:PBS - News), annual fees: 0.5%
• PowerShares Dynamic Networking Portfolio ETF (AMEX:PXQ - News), annual fees: 0.6%
• PowerShares Dynamic Oil & Gas Services Portfolio ETF (AMEX:PXJ - News), annual fees: 0.6%
• PowerShares Dynamic Pharmaceuticals ETF (AMEX:PJP - News), annual fees: 0.6%
• PowerShares Dynamic Retail Portfolio ETF (AMEX:PMR - News), annual fees: 0.6%
• PowerShares Dynamic Semiconductors Portfolio ETF (AMEX:PSI - News), annual fees: 0.6%
• PowerShares Dynamic Software Portfolio ETF (AMEX:PSJ - News), annual fees: 0.6%
• PowerShares Dynamic Technology Sector Portfolio ETF (AMEX:PTF - News), annual fees: 0.6%
• PowerShares Dynamic Utilities Portfolio ETF (AMEX:PUI - News), annual fees: 0.6%
• First Trust Technology AlphaDEX ETF (NYSEArca:FXL - News), annual fees: 0.7%
• First Trust Consumer Discretionary AlphaDEX ETF (AMEX:FXD - News), annual fees: 0.7%
• First Trust Consumer Staples AlphaDEX ETF (AMEX:FXG - News), annual fees: 0.7%
• First Trust Energy AlphaDEX ETF (NYSEArca:FXN - News), annual fees: 0.7%
• First Trust Financials AlphaDEX ETF (NYSEArca:FXO - News), annual fees: 0.7%
• First Trust Health Care AlphaDEX ETF (NYSEArca:FXH - News), annual fees: 0.7%
• First Trust Industrials AlphaDEX ETF (NYSEArca:FXR - News), annual fees: 0.7%
• First Trust Materials AlphaDEX ETF (NYSEArca:FXZ - News), annual fees: 0.7%

A handful of international oriented ETFs allow exposure abroad:

• PowerShares FTSE RAFI Asia Pacific ex-Japan ETF (NYSEArca:PAF - News), annual fees: 0.8%
• PowerShares FTSE RAFI Developed Markets ETF (NYSEArca:PXF - News), annual fees: 0.75%
• PowerShares FTSE RAFI Developed Markets ex-US Small-Mid Portfolio ETF (AMEX:PDN - News), annual fees: 0.75%
• PowerShares FTSE RAFI Emerging Markets Portfolio ETF (AMEX:PXH - News), annual fees: 0.85%
• Finally there are various hard-to-classify ETFs:
• PowerShares Active AlphaQ ETF (NYSEArca:PQY - News), annual fees: 0.75%
• PowerShares Dynamic Developed International Opportunities Portfolio ETF (AMEX:PFA - News), annual fees: 0.75%
• PowerShares Dynamic MagniQuant Portfolio ETF (AMEX:PIQ - News), annual fees: 0.6%
• PowerShares Dynamic Market Portfolio ETF (AMEX:PWC - News), annual fees: 0.6%
• PowerShares Dynamic OTC Portfolio ETF (AMEX:PWO - News), annual fees: 0.6%

Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.