The lastest: Invesco PowerShares FTSE RAFI US 1000

This exchanged traded fund (ETF) provides a route for investors to take low-cost, passive exposure to US equities using an alternative index to the S&P 500 and focusses on company fundamentals rather than market capitalisation.

As a result, the index tends to have a ‘value’ style bias, relative to the S&P 500.

Over the last few years, index trackers have regained significant traction with investors who are looking for low-cost, transparent investment vehicles. One market in particular where investors have tended to favour passive trackers is large-cap US equities, where a significant proportion of active managers have struggled to beat the benchmark after taking their own fees. As a result, the most popular ETFs in the UK are those tracking the S&P 500.

However, there can be problems with using price-weighted indices such as the S&P 500 as investment vehicles. For a start, they have a natural tendency to favour rapidly growing companies, regardless of quality.

The reason is simple – as stocks gain momentum, investors pile in, which pushes up the price, meaning its weight in a price-weighted index increases. Ultimately, investors can end up being overweight to stocks which may have already realised a lot of their growth potential. Such indices are therefore very susceptible to mispricing risk, and may end up buying into bubbles and suffering disproportionately when the market corrects (and possibly risk selling out at the bottom, missing out on any recovery).

To mitigate this, investors can instead opt for an ‘alternative beta’ index – these are still passive, rules-based indices, but use a different system to select and weight the stocks.

The Invesco Perpetual FTSE RAFI US 1000 index is based on the Research Affiliates Fundamental Index (RAFI) range, which still follows a robust, quantitative process but uses fundamental business measures and ignores share prices.

The process itself is pleasantly simple. RAFI takes four fundamental measures of a business – revenue, cashflow, dividend and net asset value. For each measure, the total value for the whole listed universe is taken and the company’s proportion of that total is used. For example, let’s say the total annual sales of all US-listed companies is a notional $5trn, and Google’s annual sales are $50bn – Google therefore accounts for 1% of total sales.

The same is then carried out for the cashflow, dividend and book value, and finally the average is taken to give a weighting in the final index (which in reality is actually around 0.42%). For the Invesco PowerShares FTSE RAFI US 1000, the 1000 largest stocks in this list are taken and weighted accordingly, with a rebalance performed annually.

By using four different metrics, the process removes most of the bias that can favour particular types of companies. For example, just ranking by revenue would favour high volume, low margin businesses such as Walmart – but these will usually have lower cashflows.

By focusing on fundamental business measures only, this index removes mis-pricing risk on both the up and down side, and means the ETF will have a bias towards value stocks compared to an index such as the S&P 500.

The Invesco Perpetual FTSE RAFI US 1000 ETF could be considered as a potential complement or even substitute to existing growth-biased US equity funds, including S&P 500 trackers.

The fund has returned 60% over three years.

 Ben Seager-Scott is senior research analyst at Bestinvest