New ETFs Take Different Twist On S&P Indexes

February 22, 2008

Market-cap-weighted ETFs (exchange-traded funds) are being pushed by all sorts of alternatives, from Rob Arnott's fundamental-based strategy to WisdomTree's dividend and earnings focus.

But a new twist is coming. A trio of ETFs are launching Friday, each an offshoot of popular Standard & Poor's benchmarks. They'll use the same stocks as their traditional S&P benchmarks. However, the ETFs will weight names by revenue rather than market-cap sizes.

The RevenueShares Large Cap Fund (NYSE: RWL) seeks to take the best of the S&P 500. Meanwhile, the RevenueShares Mid Cap Fund (NYSE: RWK) is designed to complement the S&P 400. Also, the RevenueShares Small Cap Fund (NYSE: RWJ) replicates the holdings of the S&P 600.

"We really believe in indexing and we'd never suggest people take money out of market-cap-weighted ETFs following these S&P indexes," said Sean O'Hara, president at RevenueShares Investor Services. The Philadelphia-based sponsor is marketing the new ETFs.

"The (new) underlying indexes were created so people don't fall prey to security selection bias," O'Hara added.

By that he's referring to a host of providers who've developed special benchmarks to compete with market-cap-weighted versions.

For example, O'Hara says screening U.S. companies by highest dividend yields would cut around 120 stocks from the S&P 500. The same holds true to varying degrees with other valuation metrics such as book-to-value and earnings.

"We wanted to stick with the same names as the S&P indexes," O'Hara said. "At the same time, we wanted to find ways to add some value by weighting stocks differently."

Of the major fundamental metrics being used, he says revenue proved to be the most efficient way to keep the S&P benchmarks' same lineup while providing some different patterns of return.

"There's a whole lot of debate about alternative indexing," said O'Hara. "But these ETFs aren't actively managed and they're not to replace traditional indexing. We consider these as complements to market-cap-weighted ETFs and to be used as tools in a diversified portfolio."

The idea for a revenue-weighted index was developed by Vince Lowry and his VTL Associates. RevenueShares was hired to do sales and marketing and S&P will maintain the new indexes.

The revenue-based ETFs will start out charging 0.49% in annual fees. Some analysts are expressing reservations about such a price tag, pointing out that some large-cap core ETFs set fees at 10 basis points or less.

RevenueShares responds on several fronts. For one, they say over 10-year rolling periods, backtested data shows revenue weightings don't change the split between value and growth measurably. That deviates from many other alternative indexing strategies which developed benchmarks heavily skewed to value-styled stocks.

As to expenses, O'Hara says, "It's a valid criticism."

"If I told you that you could buy a cap-weighted version of the S&P 500 for nine basis points and a revenue-weighted version for 49 basis points, you'd choose the cheaper option every time," he noted.

But that doesn't tell the whole story, O'Hara argues. For example, from 1991-2007, the S&P 500 returned an average annualized 11.41%. For the same period, RevenueShares' backtested data shows the S&P 500 weighted by revenue would've returned 14.19%.

Taking 49 basis points from the latter would leave a 13.6% return. Then, taking nine basis points from the other would put net returns at 11.32%.

"You have to realize the risks as well. But backtested results point to a revenue-based S&P 500 having higher Sharpe ratios and similar standard deviations," O'Hara said. "So we're not creating an index with higher returns but higher risks."

Those are results that appear to be quite different from what Arnott's research asserts.

Research Affiliates, the firm Arnott heads, has developed RAFI indexes (and corresponding PowerShares ETFs). The main fundamentals used to determine weightings as well as index composition are sales, dividends, cash flows and book values.

Benchmarks designed by Research Affiliates don't try to mimic anything else currently on the market. But in terms of exposure in the U.S., its closest comparison to RevenueShares would be the PowerShares FTSE RAFI U.S. 1000 Portfolio (NYSE: PRF) and the PowerShares FTSE RAFI U.S. 1500 Small-Mid Portfolio (NYSE: PRFZ). Both carry expense ratios capped at 0.60%.

Arnott's research over long periods indicates that using one valuation metric over another results in only minor performance differences. Revenue works best in his models during bull markets, while dividend-based indexes tend to outperform in more bearish cycles.

WisdomTree takes a different approach. It has developed unique indexes for ETFs which emphasize either earnings or dividends.

Along those lines, an alternatively weighted competitor to RevenueShares' RWL could be the WisdomTree Earnings 500 Fund (AMEX: EPS). It charges an expense ratio of 0.28%. The fund only includes companies that've produced positive cumulative earnings over the past four quarters.

The WisdomTree MidCap Earnings Fund (AMEX: EZM) takes a similar tack as does its SmallCap Earnings Fund (AMEX: EES). Both have expense ratios of 0.38%.

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