New Financial ETF Historically Strong

The never-ending quest for better mousetraps continues as PowerShares nine sector ETFs that apply Robert Arnott's fundamental indexing methodology of weighting for book value, income, sales and dividends.

This article will focus on the PowerShares FTSE RAFI Financials Sector Portfolio (PRFF Quote).

In the Powershares literature, the fund compares itself and its returns to the iShares Dow Jones Financial Sector ETF (IYF Quote) and the S&P Financial Sector SPDR (XLF Quote).

All three look to be very similar. They all have large positions in the same mega-cap names; Citigroup (C Quote), Bank of America (BAC Quote), JPMorgan Chase (JPM Quote) and Wells Fargo (WFC Quote).

The three funds also have similar weightings in capital-markets names and REITs and tilt toward value over growth.

So on the surface, there's not much difference. But as is the case with most new ETFs, the back test is the compelling question when considering the PRFF.

In this chart, the back test for PRFF is the leader in orange, the S&P Financial Index in brown and the Dow Jones Financial Index in blue. That the PowerShares back test looks so strong is not a shock for two reasons.

From a cynical standpoint, if the results of a back test were horrible, it is reasonable to believe there would be no fund launched.

From a more fundamental standpoint, it's not surprising a strategy that generally favors value over growth would show better returns in a sector that is more of a value-oriented part of the market.

PowerShares FTSE RAFI Financials Sector Portfolio Back Test

One contributing factor to PRFF's outperformance might be the smaller weighting in Citigroup.

Over the past five years, Citigroup has lagged both IYF and XLF by a noticeable amount. Citigroup is weighted at 7.86% in IYF, 9.8% in XLF, but only 4.26% in PRFF.

Citigroup, as a mega-cap, has been the wrong part of the market, and like most mega-caps, it has lagged its sector. There is no guarantee this will persist, and in fact, it is a reasonable that mega-caps will lead the market again. But the exact timing can only be guessed.

What makes analyzing the PRFF's better returns difficult is being able to access the history of portfolio changes as applied to the back test. I was not able to find this information on either the PowerShares or Research Affiliates Web sites. I chose not to inquire directly because in writing this article, I want to take the same tact that a do-it-yourself investor would be able to take in trying to decide whether to buy this fund.

And that is the question: Should this fund be bought?

I do not believe in speculating on a sector that you believe will do well. For me, the context is if you build a portfolio and access sectors by using sector funds, is PRFF the best way to own the financial sector? I am not sure we can know yet, because the fund is so new and all we have to go on is back testing. I do believe in the concept implemented by Arnott and applied to this fund, and I would not be the least bit surprised to see this fund continue to beat its competition, IYF and XLF.

Citigroup (C) Daily

But for my clients that do own IYF, I would want to see more of a real-world track record (as opposed to just relying on the back test) before making a switch.

A last point would be that even if PRFF does turn out to be a better mousetrap, at some point in the future something else may come along that is better still. Anyone relying on investment products for their portfolio need to stay on top of the new products coming to market. Despite what seems like a lot of new ETFs lately, there will continue to be innovation in new products like PRFF.