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How Revenue Weighted ETFs Work

Cinthia Murphy

OppenheimerFunds is known for its revenue-weighted ETFs, which today command nearly $2 billion in combined assets. The lineup of nine ETFs includes the likes of the Oppenheimer Large Cap Revenue ETF (RWL) and the Oppenheimer Small Cap Revenue ETF (RWJ), each with more than $520 million in assets.

Sharon French, head of beta solutions for the firm, tells us what’s unique about revenue weighting, when it works best and how it compares to market-cap and price weighting—two hugely popular approaches in U.S. equity investing.

ETF.com: Why do you think revenue weighting is a better approach to equity exposure relative to price weighting and market-cap weighting?

Sharon French: It gives you diversified exposure to the market, but it's not influenced by stock price. It's a truer indicator of a company's value, because it can't be manipulated by accounting practices. And it provides better and more stable sector exposure, because top-line revenue really tends not to fluctuate as much as stock price.

Using market-cap weight, you have an issue that relates to trendier sectors or overvalued stocks. From a risk management perspective, this is a better way to go. Revenue  weighting returns an index to its real economic footprint.

ETF.com: Your research looks into different predictors of a company's value, and it argues that price-to-sales is the best predictor. Why? And how is that metric captured in a revenue-weighting scheme?
Our research shows that price-to-sales is the best indicator of future returns, compared to other common value weights of metrics such as price-to-earnings, price-to-cash-flow, price-to-book. Of all of these, it has the highest predictive power for 10-year returns. A revenue-weighted ETF takes an underlying basket of stocks and it right-sizes them based on their revenue. A byproduct of this is lower valuations, and specifically price-to-sales.

The reason we grew assets 100% in our first year is because advisors really understand this. That really helps them lower the price-to-sales of a particular asset class or core allocation in their book.

ETF.com: Revenue itself is not a traditional factor, but does a revenue-weighted portfolio capture some of these factors? Should it be considered as a quality portfolio?

French: That’s the right way to think about this. Revenue’s not one of the traditional factors. If you think about smart beta being equal weight, fundamental weight, single factor, multifactor, it fits squarely in the fundamentally weighted methodology within smart beta. Revenue weighting does two things to the factors in a portfolio.

First, it tilts the portfolio toward value. Value investing takes discipline, and it's been shown to outperform expensive companies over long periods of time. Value has had an incredible run since the elections, and a lot of people are saying we're going into a more permanent value cycle.

Second, it reduces the portfolio's momentum. Revenue doesn't really trade off of price. And like most value strategies, it takes a contrarian look at the market's expectations. While we recognize momentum as a long-term driver of return, sometimes its volatility and drawdowns are high.


ETF.com: Is there any sort of cyclicality to the performance of a revenue-weighted portfolio? Are there clear periods of underperformance, as with other factors?

French: It generally does better in a value market. Our large-cap fund, for instance, will underperform a narrowing and growth-oriented market like the dot-com bubble, and outperform in value markets because of its tilt to size and value. However, over time, it's outperformed well-known large cap indices like the Russell 1000, Russell 1000 Growth and Value, S&P 500 and the S&P 500 Growth and Value.

ETF.com: What about this idea that revenue, as a metric, can't really be manipulated, unlike earnings, for example? Companies can use aggressive revenue recognition practices that lead them to overstate their revenue, right? How does your methodology account for this possible type of manipulation?

French: It's very infrequent, but as you know, accounting fraud does happen, even for public companies. We're not saying revenue can't ever be manipulated, but it’s much less subjective than other items further down the balance sheet, like net income.

With revenue, you only have two roles surrounding it:

The completion of the earnings process, which means the company has provided all or virtually all of the goods and services for which it has to be paid.

Assurance of payment—there must be a quantification of cash or assets that'll be received for realized goods and services. If somebody were to go as far as to do some sort of these aggressive accounting recognition techniques, they would either have to recognize the delivery that hasn't occurred, or they have very, very loose return policies, prices that aren't fixed. Again, I’d say it's very infrequent. Certainly, amongst all the other choices, it's the one that gets manipulated the least. And there's nothing we can do in order to prevent that.

But let me point out that we look at the trailing four quarters of revenue so that we're not skewed or biased from advanced revenue recognition in one corner or seasonality. Where revenue can increase or decrease from year to year, we can expect that a company's revenue growth should be somewhat similar to that of its peers or industry. And if they're not, we can certainly investigate it.

And to go back to what you said earlier, we actually do consider revenue a quality screen. We think it could work well as that, and some people have used it as that. The methodology makes low-quality companies—the ones with smaller economic impact—fairly small in the portfolio by providing a noticeable tilt toward higher revenue firms.

ETF.com: Larger revenue firms don't necessarily mean larger market capitalization firms, correct? You can have a successful really small company.

French: Absolutely. It's funny, because you don't even have to have earnings. Not every company has earnings. A lot of people are surprised by that. We also get a lot of questions around dividends. Paying dividends is a management decision. That’s why when pursuing all other options, revenue stands the test of time.

ETF.com: What are the biggest risks here? What should investors watch out for if choosing revenue-weighting?

French: I have to tell you, I've never gotten that question before. What I have gotten is, when is it not going to work? It's never not going to work, it's just not going to work as well in the narrower growth-oriented environment.

But we see that people are thinking about this, and using this as a core replacement, not just a value play. We're always encouraging everyone to look at their equity portfolios and challenge the index, challenge conventional thinking. Buying the market in a market-cap-weighted strategy is not the best way. Look at alternatives, like revenue-weighted strategies, where you can get those same companies with cheaper valuations.

There is risk in buying the market because of trendier sectors and overvalued stocks. I think this is a better risk-adjusted alternative, but know that if we happen to go into a growth cycle, it won't do as well.

Contact Cinthia Murphy at cmurphy@etf.com


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