In Part II of this Indexing Redefined four-part series, the article examined how fundamental indexing can be applicable to style boxes. In particular, anchoring core, value, and growth allocations to observable economic scale as opposed to simply using price momentum. By replacing speculative narrative with measurable business metrics rather than stock prices, Research Affiliates’ strategies can avoid speculative growth bubbles and prevent costly buy-high, sell-low index additions.
In Part III, the focus will center on practical applications of this discipline. In particular, how advisors can integrate the methodology into modern asset allocation, and why it offers an evolutionary leap for passive investing that’s available through exchange-traded funds (ETFs).
Key Takeaways:
- Fundamental indexing can be integrated alongside traditional market-cap benchmarks as a core equity replacement or satellite strategy to reduce mega-cap concentration risk and harvest rebalancing alpha.
- Advisors can access Research Affiliates (RAFI) methodologies across domestic market caps via ETFs like Schwab’s FNDX and FNDA or Invesco’s PRF, PRFZ, IUS, and the hybrid market-cap-weighted RAUS.
- For international allocation, strategies such as FNDF, FNDE, PXF, PDN, and PXH extend fundamental weighting across developed and emerging markets to prevent regional price distortions.
See More: Indexing Redefined, Part II: Core, Value, & Growth Exposure
Portfolio Construction in Modern Markets
For financial advisors and investors, adopting fundamental indexing strategies does not require a complete overhaul of existing portfolio models. Rather, fundamental strategies can be seamlessly integrated alongside traditional core allocations to enhance overall portfolio diversification.
In modern portfolio construction, fundamental strategies can serve two primary functions. First, they can act as a core equity replacement or satellite. Investors can choose to allocate a portion of a portfolio’s core equity sleeve to fundamental index strategies for reducing concentration risk in mega-cap tech names while maintaining broad-market exposure. Second, they enable factor-disciplined tilting, as RAFI Fundamental Index and RAFI Growth are more efficient ways of capturing the value and growth premiums, respectively.
Investors also don’t have to scrap their market-cap weighted exposure. By blending market-cap funds (that capture market momentum) with fundamental index strategies (that capture rebalancing alpha), advisors create a complementary asset allocation structure where both can work in tandem with one another. This dual-engine approach can smooth the volatility journey for clients while improving overall capital efficiency across shifting market regimes irrespective of whether growth or value is leading.
In the current market environment, concentration is already reaching historic highs in cap-weighted indexes. That said, investors are increasingly recognizing that traditional passive investing carries active valuation risks as market-cap-weighted indexes continue purchasing overinflated constituents. Reframing index construction around an economic footprint offers advisors and individual investors a compelling alternative.
RAFI Accessibility Through ETFs
Exposure to fundamental indexing is readily accessible through low-cost ETFs. A prominent example is the suite of fundamental equity ETFs offered by Charles Schwab, which track Research Affiliates Fundamental Index (RAFI) methodologies. Among these, the Schwab Fundamental U.S. Large Company ETF (FNDX) uses fundamental indexing strategies to search for opportunities in large-cap U.S. equities. Similarly, the Schwab Fundamental U.S. Small Company ETF (FNDA) applies fundamental weighting to a small-cap segment that has been drawing greater investor attention this year. FNDA insulates investors from the high proportion of unprofitable companies found in cap-weighted small-cap benchmarks.
Invesco’s suite of fundamental factor ETFs adds further versatility for core and style-pure allocations. For broad domestic core exposure, the Invesco RAFI US 1000 ETF (PRF) anchors 1,000 of the largest U.S. equities to their overall economic footprint, serving as a price-agnostic core replacement for traditional market-cap benchmarks. To complement large-cap holdings across the full market-cap spectrum, investors can integrate the Invesco RAFI US 1500 Small-Mid ETF (PRFZ), which applies the same fundamental weighting framework across domestic small- and mid-cap equities.
ETFs for Quality and Market-Cap Weighting
Those seeking a quality-tilted core can utilize the Invesco RAFI Strategic US ETF (IUS), which tracks the Invesco Strategic US Index which combines fundamental weighting with a quality screen in the U.S. large company space. The fund assigns eligible securities a business-size score based on a five-year average of sales, operating cash flow, book value, and total returned capital. It then filters these names using an equally weighted quality score composed of operational efficiency (sales-to-assets ratio) and historical sales-to-assets growth. By weighting the resulting high-quality holdings by their float-adjusted business-size scores, IUS establishes a disciplined, quality-screened core for U.S. equity exposure.
For investors seeking to retain market-cap weighting while incorporating the fundamental methodology, the Research Affiliates Cap-Weighted US ETF (RAUS) offers a compelling hybrid option. RAUS uses the RACWI index methodology discussed in Part II by using the fundamental strategy to select index constituents before weighting them by market capitalization. This hybrid design allows investors to maintain the familiar liquidity, low turnover, and minimal tracking error of a broad market-cap index. However, it also insulates the portfolio from overvalued, speculative stocks.
Using RAFI Outside of U.S. Borders
Investors looking to utilize the fundamental strategy discipline globally can access international developed and emerging markets (EM) ETFs. For example, the Schwab Fundamental International Large Company ETF (FNDF) extends fundamental index discipline across developed international markets to capture diversification outside of U.S. borders without price distortion. To expand its global footprint even further, the Schwab Fundamental Emerging Markets Equity ETF (FNDE) utilizes the fundamental strategy when looking for opportunities in emerging economies.
Additionally, the Invesco RAFI Developed Markets ex-U.S. ETF (PXF) provides fundamental weighting across broad non-U.S. developed large-caps, while the Invesco RAFI Developed Markets ex-U.S. Small-Mid ETF (PDN) applies this value-oriented discipline to international small- and mid-cap equities. Completing the global suite, the Invesco RAFI Emerging Markets ETF (PXH) anchors emerging market exposure to the fundamental strategy.
Innovation and Cost-Efficiency
The aforementioned funds are just some of the product offerings available using strategies developed by RAFI Indices. By shifting the definition of passive investing from price to economic footprint, fundamental index strategies provide a resilient foundation for today’s wealth management practice.
In today’s competitive ETF landscape, providers can gain market traction by offering low-cost accessibility and innovation. RAFI ETFs, in particular, do both. They deliver the cost efficiency and transparency of indexing alongside the potential for outperformance by decoupling the link between stock price and index weight.
How does the RAFI methodology stack up against active management? This will be explored in fourth and final installment of this series.
Originally posted on ETF Trends
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VettaFi LLC (“VettaFi”) is the index provider for FNDX, FNDA, PRF, PRFZ, IUS, RAUS, FNDF, FNDE, PXF, PDN, and PXH, for which it receives an index licensing fee. However, FNDX, FNDA, PRF, PRFZ, IUS, RAUS, FNDF, FNDE, PXF, PDN, and PXH are not issued, sponsored, endorsed, or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of FNDX, FNDA, PRF, PRFZ, IUS, RAUS, FNDF, FNDE, PXF, PDN, and PXH.
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