How Stocks With Strong Fundamentals Beat the S&P

The S&P 500 (^GSPC 0.87%) has risen to record highs recently, with exceedingly strong performance since the stock market bottom more than four years ago. Yet for those willing to take a different tack to achieve superior performance to the S&P, one large-cap alternative has given investors even better returns over its seven-year history.

The PowerShares FTSE RAFI US 1000 ETF (PRF 0.84%) has the same goal of tracking the performance of the largest stocks in the U.S. market, with a diversified portfolio of roughly 1,000 different stocks among its holdings. But unlike SPDR S&P 500 (SPY 0.92%) and other S&P-tracking ETFs, the PowerShares ETF uses a different standard in choosing and weighting the stocks in its portfolio. Let's look at the fund and se why it has achieved such good performance recently.

The fundamentals of stock selection
Invesco, the company behind the PowerShares ETF, believes that the S&P 500 and market-cap weighted indexes have inherent problems. It argues that overvalued stocks get disproportionate representation in cap-weighted indexes, leaving index investors exposed to disruptions caused by market speculation and volatility. By looking to current share price, cap-weighted indexes incorporate future expectations that might well be unrealistic.

To avoid the perils of cap-weighted indexes, the PowerShares ETF uses a proprietary weighting formula based on five-year averages of sales, cash flow, and dividends, as well as current book value. With all of these figures being backward looking, the methodology avoids the uncertainty of looking forward, instead relying on the tendency of large-cap companies to continue growing at a similar pace, with only slow adaptations to changing market conditions.

What's behind the ETF's strength?
That methodology has helped the PowerShares ETF beat the S&P by more than six percentage points in the past year and by an average of almost two percentage points annually since the fund's inception in late 2005. Surprisingly, that outperformance comes even after considering the relatively high 0.39% expense ratio the PowerShares ETF has.

In particular, the PowerShares ETF has made some adroit weighting choices. What's helped the index most in recent years has been its high weighting of banking stocks, with four top banks among the top eight stocks on its holdings list. Over the past year, a huge part of its performance has come from underweighting Apple, which made up just 0.72% of the ETF as of June 30, compared with more than 2.5% of the SPDR S&P 500 ETF. The emphasis on high-dividend stocks has also helped the PowerShares ETF in recent years, as dividend-paying investments have outperformed during the low-interest rate environment that sent income investors scurrying for ways to boost portfolio income.

Will the outperformance continue?
Over shorter periods, the PowerShares ETF hasn't always beaten the S&P. During the bear-market year of 2008, the fund fell well short of the S&P, and it also lagged during the relatively flat years of 2007 and 2011. But with longer-term performance supporting the advantages of the fund's philosophy, investors should at least consider the benefits of fundamental weighting when putting together the index-tracking side of their investment portfolios.