Richard Drury
There is no question that ETFs with value-oriented approaches have struggled to compete with broader market benchmarks, such as the Russel 1000 and S&P 500 indexes, as mega-caps, mostly from the technology sector, have led the stock market for quite some time.
Despite that, portfolios following value-oriented strategies still have some appeal, particularly now that valuations are stretched again. The investment approach adopted by the Invesco FTSE RAFI US 1000 ETF (NYSEARCA:PRF) resonates with this scenario. This ETF follows an index based on fundamental measures, resulting in a portfolio with substantially lower valuation multiples compared to the benchmark.
While valuations are generally low even compared to the peer group of value-oriented ETFs, PRF has underperformed the category over time, likely influenced by its lower allocation to mega and large caps, and a sector exposure heavily underweight in the technology sector has likely influenced total returns.
Therefore, although its investment methodology is expected to draw attention from investors looking for value, I do not see a large allocation warranted to this ETF given its sup-par track record over time.
ETF Description & Highlights
PRF is an exchange-traded fund that is based on the FTSE RAFI US 1000 index. This index is composed of 1000 equities among the largest U.S. companies with the highest fundamental weights.
This fundamental weight is calculated for each security according to four accounting measures: adjusted sales, adjusted cash flow, dividend plus buybacks, and book value plus intangibles. Generally speaking, these measures are calculated factoring in the 5-year average and other metrics like equity to assets ratio and R&D expenses. The average of these four measures is then used to weight each company to constitute the index. Every quarter, a tranche that equals one-fourth of the index is rebalanced. On top of that, the whole index is reconstituted annually.
As a result of this approach in the stock selection, the FTSE RAFI US 1000 index has a slightly different composition compared to the Russell 1000 index, with nearly 20% of FTSE RAFI US 1000 index holdings that are not included in the Russell 1000 index.
It is also reflected in the top ten holdings of the FTSE RAFI US 1000 index and PRF (Exxon, Berkshire, Apple, Microsoft, JPMorgan, Amazon, Verizon, Bank of America, Chevron, and Citigroup), mostly from financials and energy sectors, as opposed to the Russell 1000 index, where the majority are technology names (Microsoft, Nvidia, Apple and Broadcom) or from the communication services sector (Meta and Alphabet).
Additionally, PRF’s stock composition has a smaller allocation to so-called mega caps, with an average market cap of $94 billion compared to $234 billion for the Russell 1000 index, represented in this analysis by the iShares Russell 1000 ETF (IWB). We can also see that PRF’s top ten holdings account for 17% of total assets, almost half of the Russell 1000s top ten holdings allocation of 32%.
Morningstar, consolidated by the author
Below is a comparison between PRF and a large-cap ETF peer group with a value-oriented approach. The first and the third ETFs (FNDX and IUS) follow RAFI indexes with a fundamental approach, while PMV and VTV track value-oriented indexes. On the other hand, JQUA has a quality profile, and FFLC is an actively managed ETF.
As a remark, we can see PRF has a much more diversified allocation, with nearly 1000 holdings, compared to the peer group’s average of 338 holdings. In addition, the peer group is more skewed toward large caps, with nearly 71% allocated to large caps and so-called giants or mega caps, versus 61% for PRF.
Morningstar, consolidated by the author
From a sector allocation perspective, as of June 6, 2024, PRF‘s largest allocation is to the financial sector, with 19.4% of total equities, followed by technology with 13.2%, healthcare 12.6%, consumer cyclical 9.4%, industrials 9.3%, communication services 8.4%, consumer defensive 8.3%, energy 7.9%, utilities 4.8%, real estate 3.6% and basic materials 3.2%. Relative to the Russell 1000 index, PRF is mainly overweight in financials (+6.8%) and energy (+4.2%) while heavily underweight in technology (-17.8%).
Morningstar, consolidated by the author
Compared to the peer group of large-cap ETFs, PRF is also overweight in financials but underweight mostly in industrials (-4.2%) and technology (-3.0%). This relatively small sector allocation discrepancy with the peer group is expected since all ETFs used in this comparison have a value-oriented bias, which explains their limited exposure to a high-valuation sector such as technology.
Morningstar, consolidated by the author
From a valuation perspective, PRF shows significantly lower multiples relative to the Russell 100 index, with at least a 29% gap to this benchmark. On the other hand, growth metrics are only slightly lower. This suggests that the FTSE RAFI’s methodology has successfully captured underlying valuation inefficiencies across the market, as there is not enough divergence in the average growth profile to justify such a sizable discrepancy in multiples.
Morningstar, consolidated by the author
Curiously, in comparison with the peer group of ETFs, while PRF’s price/earnings ratio shows a small premium, we see PRF with a significant valuation gap in terms of price/book and price/sales ratios relative to the peer group, very likely due to the fundamental measures used in the FTSE RAFI US 1000 index construction, which include adjusted sales and book value rather than the more commonly used price/earnings ratio.
Morningstar, consolidated by the author
Underperforming Benchmarks And The Peer Group
The comparison of PRF with the Russell 1000 and the S&P 500 indexes is unsurprisingly adverse to PRF, as value-driven approaches have struggled to keep pace with these benchmarks, given the leadership of high-growth mega caps seen over the past decade or so.
Morningstar, consolidated by the author
Compared with the peer group of large-cap value ETFs, PRF’s returns have been roughly in line with the pack over longer timeframes. However, PRF has delivered a sluggish performance in the past three years. Of course, it should be put into the context of a difficult period for value stocks, but this weak performance on a relative basis is certainly not welcome for PRF’s investors.
Morningstar, consolidated by the author
PRF’s risk-adjusted returns and volatility measures have not been great either, as its Sharpe ratios have generally been lower than those of benchmarks and the peer group, while its standard deviation and maximum drawdown have been consistently higher across all timeframes. The exception is the comparison with the Russell 1000 index for the 3-year period, where the benchmarks had worse readings than PRF and other value ETFs.
Morningstar, consolidated by the author
My view is that PRF’s underperformance compared to its peers is at least partly due to the approach used by its parent index, as it selects stocks with lower price/sales ratios on average. While this is supposed to be a valid criterion, under current market conditions where investors have been quite fixated on growth, portfolios with lower price/sales ratios may drag the performance of growth-oriented strategies. In particular, PRF’s average price/sales ratio is way lower than that of the peer group, which has likely exacerbated this effect over time.
On the flip side, looking ahead, in my view, earnings growth is needed to lift the stock market from here, especially with valuations at these levels. That said, with many stocks having high-growth expectations already priced in, there may be a good setup to drive a rotation to sectors with lower valuations.
With that in mind, I see PRF as a valuable alternative for investors looking to diversify toward value-oriented portfolios, as this ETF certainly shows lower valuations compared to the Russell 1000 or S&P 500 indexes. On the other hand, given its underperformance relative to the peer group of ETFs following value-oriented strategies, I see no reason to maintain an outsized position in PRF, but rather a relatively small allocation for diversification purposes.
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