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'Large-Cap' ETF Has Smaller-Cap Leanings

Recently I had the chance to attend a breakfast at the NYSE held by PowerShares as part of its rollout of the FTSE RAFI US 1000 (PRF) exchange-traded fund.

The index is based on the work of Robert Arnott, who has done a tremendous amount of innovative research to try to make index investing more efficient. PRF's methodology involves screening for book value, earnings, revenue and dividends. Each stock gets a score based on the criteria, and is then weighted in the index based on its score.

The motivation for creating this index, and by extension the fund itself, is Arnott's belief that ordinary market-cap weighting of indices creates a bias toward growth stocks that are overvalued. By quantitatively scoring potential components, the process removes the growth bias.

The track record for success, based on Arnott's back testing, is excellent. It beat the S&P 500 hands down in seemingly every market condition, and does so with a slightly higher dividend yield.

Furthermore, early indications are that the methodology works for foreign stocks too, both emerging and developed.

You might think it's time to back up the truck. Not so fast, my friend.

Despite the fact that PRF and the S&P 500 currently overlap General Electric (GE - Get Report), Exxon Mobil (XOM - Get Report), Microsoft (MSFT - Get Report) and Citigroup (C - Get Report) in their top four, it looks as though PRF has closer correlations to small-cap value as measured by the iShares S&P Small Cap 600/Barra Value (IJS) fund and mid-cap value as measured by the iShares Russell Value Index (IWS) fund.

At the breakfast, Arnott touched on the fact that PRF does tend to have a smaller cap than the S&P 500, with a tilt toward value.

From this table it appears that PRF might be a better proxy for mid-cap value or small-cap value.

Recent Performance
ETF/Index 2001 2002 2003 2004 2005*
PRF 1.79% -17.86% 33.96% 14.82% 4.59%
IJS 15 -14 35 22 4.9
IWS N/A -13 34 18.9 7.8
SPX -11.89 -22.1 28.68 10.88 2.75
*Through September 30, 2005
Source: Your Source Financial

Admittedly, this may be too short a time period to look at, but the last few years have had feast, famine and flat returns, and PRF is repeatedly closer to the mid-cap value and small-cap value results than it is to the S&P 500 results.

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SYM TRADE IT LAST %CHG
C $52.90 0.00%
GE $26.80 0.00%
IJS $119.55 0.00%
IWS $75.81 0.00%
MSFT $47.87 0.00%

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DOW 18,080.14 +21.45 0.12%
S&P 500 2,117.69 +4.76 0.23%
NASDAQ 5,092.0850 +36.0220 0.71%

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