The ETF industry has traditionally been dominated by products based on market capitalization weighted indexes that are designed to represent the market or a market segment. They provide a low-cost, convenient and transparent way of replicating market/segment returns.
But many investors have realized that capitalization weighted indexes are not the most efficient way of investing, at times.
The Problem with Market-Cap Weighted Indexes
Market capitalization weighted indexes give higher weights to bigger and often over-priced companies. Further as a stock rises in value, its weight in the index increases and when it falls, its weight in the index also comes down—somewhat similar to buying high and selling low—making these strategies inefficient. (Read: 3 Niche ETFs that will keep flying higher)
Thus sensible non market-cap weighted strategies add value over capitalization weighted indexes over time. In fact, research show that even random weighting strategies like–monkey throwing darts–consistently outperform cap-weighted indexes.
Weighting on measures like revenue, earnings, cash flow, dividends have beaten the market cap weighting strategies according to numerous studies.
Why Should You Focus on Revenue?
Many analysts believe that revenues and not earnings are a better indicator of a company’s financial health as earnings are easier to “manage”. Due to Wall Street’s focus on earnings, many companies use accounting tricks to flatter earnings.
Top-line growth is transparent and difficult to manipulate and thus in my opinion one of the most effective fundamental factors for weighting the index holdings.
Revenue Weighted ETFs
RevenueShares pioneered revenue-weighted ETFs and currently sponsors seven such ETFs. Six of these ETFs indexes track the same securities as their benchmark S&P indexes, but in different weights–based on their revenue–instead of market capitalization. Thus at the time of quarterly rebalancing they are comprised of fewer higher priced stocks (based on price to revenue ratio) and more lower priced stocks.
In this article, we have highlighted three revenue-weighted ETFs tracking large cap, mid cap and small cap segments of the market. These products made their debut in February 2008.
|Index||Market Cap Weighted ETF||5 Year Return||Revenue Weighted ETF||5 Year Return|
|S&P MidCap 400||MDY||219.8%||RWK||255.2%|
|S&P SmallCap 600||SLY||260.2%||RWJ||318.6%|
RevenueShares Large Cap Fund (NYSEARCA:RWL)
RWL is comprised of the same securities as the S&P 500 index but the holdings are ranked by top-line revenue instead of market capitalization.