This strategy attempts to profit from mean-reversion in valuations.

by Alex Bryan
Invesco FTSE RAFI US 1500 Small-Mid

Invesco FTSE RAFI US 1500 Small-Mid ETF PRFZ applies a disciplined contrarian rebalancing approach that should give it an edge over the long term. While this is a solid strategy, its weighting approach may cause it to overweight stocks with deteriorating fundamentals, and it is more expensive than many of its index peers. It warrants a Morningstar Analyst Rating of Bronze.

This is a value strategy, though it doesn't explicitly target value stocks. Instead, it offers broad exposure to small-cap stocks, with a few mid-caps in the mix, and weights them based on fundamental measures of size, including book value, cash flow, sales, and dividends. This approach pulls the portfolio toward stocks trading at low multiples of these metrics, but it often does not have a noticeable value tilt.

Fundamental weighting helps the fund buy low and sell high. To rebalance to its target weightings, the fund must increase exposure to stocks that have become cheaper relative to their peers and trim positions in those that have become more expensive. These disciplined bets against the market should give the fund an edge when valuations mean-revert. However, this approach can also increase the fund's exposure to stocks with deteriorating fundamentals. This is because the metrics it uses to weight its holdings are backward-looking and slower to detect souring prospects than market prices. This strategy does not constrain its sector weightings. Rather, it attempts to take advantage of mean reversion in valuations, regardless of where they occur.

So far, this strategy has worked well. From its inception in September 2006 through November 2018, it outpaced the Russell 2000 Index by 1.5 percentage points annualized, with slightly greater volatility. Much of that outperformance was concentrated in 2009. This was partially an accident of timing. The fund rebalanced in March 2009, increasing its exposure to the most-beaten-down stocks around the time they reached bottom. When the market started to rebound, these stocks outperformed. Had the fund rebalanced at some other time, its performance advantage probably would have been smaller.

Portfolio Construction

Fundamental weighting is a compelling but imperfect value strategy. It can cause the fund to overweight stocks with deteriorating fundamentals and have inconsistent exposure to value stocks. However, it also introduces a dynamic rebalancing approach that systematically increases the fund's exposure to stocks that have become cheaper relative to their peers. This should give the fund an edge over its peers, supporting the Positive Process Pillar rating. The fund employs near full replication to track the FTSE RAFI US 1500 Small-Mid Index. This benchmark selects the 1,001-2,500 largest U.S. companies from the FTSE US All Cap Index, based on fundamental size. To determine each stock's fundamental size and weighting in the index, FTSE RAFI calculates the ratio of each stock's cash flow, sales, dividends (where applicable), and book value to the aggregate values of each of those metrics for all the stocks in the portfolio. To reduce turnover, the index uses five-year averages for each measure, except book value, where it uses the most recent figures. FTSE averages those four values to assign each stock's weighting in the index. For those stocks that do not pay dividends, the average of the other three factors determines the stock's fundamental weighting. The index is reconstituted annually in March. This approach gives the portfolio a value tilt.


The fund's 0.39% expense ratio is low relative to the Morningstar Category and reasonable for this strategy, supporting its Positive Price Pillar rating. But there are cheaper alternatives, including Schwab Fundamental U.S. Small Company ETF FNDA, which is a similar strategy that charges 0.25%. The managers generate ancillary income for the fund through securities lending. Over the trailing three years through November 2018, the fund lagged its benchmark by 26 basis points annually, less than the amount of its expense ratio. Transaction costs can create a drag on the fund's returns in March, when the fund concentrates its entire turnover.

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