Could These ETFs Be Your Ticket to Better Returns?

You can always find examples to prove the effectiveness of buy-and-hold investing . But unless you know exactly what you're doing, it's challenging to confidently construct a portfolio of long-term winning stocks. For those who prefer to steer clear of stock picking, exchange-traded funds (ETFs) provide the diversification benefits of index funds, with some of the convenience that comes from trading on stock exchanges.

Over the years, ETFs have become increasingly sophisticated. A "plain vanilla" ETF like the SPDR Trust tracks the market-cap-weighted S&P 500 index passively. But countless other ETF strategies have also become popular, from sector-specific ETFs to index ETFs that assign equal weightings to each component. Some of those methods have been successful, while others have been disastrous for investors.

It's not always the thought that counts
One such disaster is the dividend-weighted ETF. In theory, emphasizing dividend-paying companies seemed perfectly sound. Yet during the bear market, dividend stocks were among the worst-hit victims, especially those in the traditionally high-yielding financial sector. Moreover, because some dividend-weighted ETFs only made changes to their holdings once per year, they often held stocks long after their dividends had been cut.

Weighting component stocks by dividend isn't the only way to invest, however. Equal-weight S&P ETFs have beaten their traditional market-cap-weighted S&P funds in recent years, helping to boost their popularity.

Is revenue better than dividends?
Another strategy that has had good success is to weight stocks by their total revenue. Unlike dividend-weighted strategies, in which some index components will be entirely left out if they don't pay dividends, a revenue-weighted ETF will always own at least a small portion of every stock of the index.

Revenue-weighted ETFs give companies with the highest revenue the most representation in the fund, making current stock price a lot less important than it is in a traditional market-cap-weighted index. In other words, a revenue-weighted fund determines a company's importance based on its ability to generate sales, rather than its current stock price and number of shares outstanding.

One fund company, RevenueShares, has specialized in ETFs using revenue-weighted strategies. The company has had great success with its mid-cap and small-cap funds, which have beaten their market-cap-weighted SPDR ETF peers by two and 10 percentage points, respectively, since they began trading early in 2008. In the large-cap space, though, the RevenueShares ETF has underperformed the S&P 500 by about three percentage points.

One reason for the disparity may be that with large-caps, revenues track market capitalizations fairly closely. Although the weighting schemes are far from identical, you'll notice that several companies appear in the top 10 using both methods:

Source: Capital IQ, a division of Standard and Poor's. As of Oct. 5.

Another potential weakness of revenue-weighted ETFs is that they give greater weight to high-revenue, low-margin businesses than to smaller, more efficient companies. Whether that results in better or worse long-term performance remains to be seen.

Seeking the golden goose
Since ETFs arrived on the scene, their appeal as great diversification tools has faded somewhat. Now, investors want funds that will not just mimic the market, but actually outperform it on a consistent basis.

Such a golden goose has proven elusive so far, but innovative ETF companies continue to make progress toward that end, with new products coming out all the time. I expect that one day, we will see a new ETF that raises the bar for portfolio managers. With its stellar performance to date, the RevenueShares Small Cap fund has certainly become a prospective candidate in that regard.

If RevenueShares can apply that winning formula to its Large Cap and Mid Cap funds, it will be even closer to establishing its strategy as a serious contender for replacing traditional market-weighted ETFs in retail investors' portfolios.

Do you think a revenue-weighted strategy can beat the market over the long run? Share your thoughts in the comments section below.

Further reading:

• 3 Huge Value Traps You Must Avoid Today
• This Is Exactly the Time to Buy These Stocks
• This Is the Market’s Cheapest Stock