The Guggenheim S&P 500 Equal Weight ETF (RSP | A-72), which has been around for almost 11 years, is composed of the 500 stocks of the S&P 500 Index, but weights them equally and rebalances quarterly.
The methodology tilts the holdings toward relatively smaller firms, giving RSP access to the "size" factor that, on the whole, means greater returns over time than in a cap-weighting approach, according to academic research.
It also means returns are likely to be bumpier along the way, and that trading costs and tax consequences associated with the quarterly rebalancing do detract from returns.
Still, RSP has easily bested the returns of its close cousin, the cap-weighted SPDR S&P 500 ETF (SPY | A-97) in the past 10 years. RSP has risen an annualized 9 percent in that time frame, while SPY is up 6.4 percent.
RSP, at the end of the day, owns more of the smaller-sized S&P 500 constituents, giving the portfolio a higher beta than the cap-weighted SPY. That more than justifies the RSP's annual expense ratio of 0.40%, or $40 for each $10,000 invested. SPY, by comparison, has an annual expense ratio of about 0.09%, or $9 for each $10,000 invested.
Around the same time that RSP came to market, WisdomTree and Arnott's Research Affiliates were working on their own ways to overcome the "Cisco Effect."
RAFI's approach, Larsen says, has a clear aspect of behavioral economics, with a rules-based approach that arguably helps prevent investors from being their own worst enemies—"institutionalized courage," to borrow Arnott's formulation.
Specifically, both the RAFI and WisdomTree screens seek to overweight undervalued securities that have high expected returns, while also underweighting overvalued securities that have relatively depleted expected returns.
"It plays off the concept of reversion to the mean," WisdomTree's Chief Investment Strategist Luciano Siracusano said.
"It can sound complicated, but it's actually taking advantage of a very simple idea, and that is that cap-weighted indexes never rebalance back to any measure of relative value. But fundamentally weighted indexes do," he added.
"Anyone who has taken a fair look at what the returns have been over the last six or seven years after these indexes and funds have been live—including 2008, which was an important down year—the conclusion is that, on balance, these strategies have beaten the cap-weighted indexes," Siracusano noted.
To be clear, Siracusano is unabashed that fundamentally indexed funds marketed by WisdomTree should be tools to "explore the core," as he puts it.
Plenty of advisors, eager to enforce good behavior on their clients, are entirely on board with that idea.
"I buy into RAFI on a philosophical basis. I'm not sure you're going to beat the market by a ton, but for us it's going to generate some alpha and also protect us when we get into the extremes. And it does," said Nick Carver, director of investment services at Neenah, Wis.-based Legacy Private Trust Co.
Legacy Private Trust manages about $800 million in assets, half of it ETFs.
Among other securities, it uses the PowerShares FTSE RAFI US 1000 ETF (PRF | A-86). PRF has what Research Affiliates calls a "dynamic value" tilt that toggles exposure over time between "core," "value" and "deep value" swaths of the U.S. large-cap equities market.
"The RAFI methodology is big on rebalancing," Carver said. "And we're big rebalancers. We rebalance all the time. That's Arnott's point: It's a mathematical principle that if you have volatility, it's smart to rebalance."