Market cap proponents argue that the outperformance of fundamental indexes is nothing more than the result of their small-cap and value tilts, which studies from Dartmouth professor Kenneth French and University of Chicago professor Eugene Fama have shown to provide superior long-term returns.

However, Morningstar ETF analyst Alex Bryan recently wrote that a 50-country study covering the 1982-2008 period found that fundamental indexing added significant excess returns even after controlling for value and other risk exposures. The contrarian bets that fundamental indexes make may contribute to that outperformance, Bryan noted.

The differences between fundamental index ETFs and traditional index ETFs are evident by comparing the PowerShares FTSE RAFI US 1000 Portfolio (PRF) and the Vanguard S&P 500 Index (VOO) funds. Both ETFs are rated Overweight by S&P Capital IQ. PRF has an expense ratio of 0.43%, while VOO costs just 0.05%. Sixty-eight percent of VOO’s $8.5 billion in assets are in mega-cap stocks (stocks with market caps of $25 billion or more), while 57% of PRF’s $1.6 billion in assets are in mega caps. VOO has just 2% in mid-cap stocks, PRF has 10%. 

“This is a large-cap portfolio,” notes Todd Rosenbluth, director of ETF Research at S&P Capital IQ, “so the fund (PRF) has a tilt towards smaller-cap stocks, not actual small caps.” As is typical of such portfolios, PRF’s standard deviation is higher at 19.43% versus 13.04% for VOO.

VOO also is more growth stock-oriented. Information technology constitutes 19% of VOO, while that sector accounts for only 9.42% of PRF. PRF’s biggest weighting is financials at 23.6% of the portfolio.

PRF also has superior returns—6.79% annually over the past five years versus 4.99% for the S&P 500 index (VOO does not have a five year track record yet). This year, PRF is up 8.17% versus 6.84% for VOO. One factor in PRF’s outperformance is its relatively small position in Apple, which is down 19% year-to-date and is still VOO’s single largest position.

A Bad Apple

Proponents of market cap indexes argue fundamental index construction is just active management in disguise. “What you’re saying with alternative indexes is that market prices are wrong. It’s an active bet,” says Joel Dickson, Vanguard’s senior ETF strategist. “The beauty” of market-cap indexes, he says, is they reflect a comprehensive view of a stock’s value. “It’s not just dividends or cash flow or book value.”

Dickson adds that most alternative-weight ETFs end up tilting toward small-cap value stocks. “If investors want exposure to value and small-cap stocks, they can buy cheaper market-cap weighted value and small-cap ETFs,” he says.

It’s important that investors understand the indexing approach taken by their ETFs. Most market-cap weighted index ETFs currently have significant weightings in Apple. But Apple has been one of the worst performing stocks in the S&P 500 this year.