2023-03-08 05:25:17 ET
Summary
- PRF selects 1,000 large-cap U.S. companies based on four factors: dividends, free cash flow, sales, and book value. Fees are 0.39% and the ETF has $6 billion in assets.
- The portfolio is solid and well-diversified. However, there are cheaper alternatives with better long-term track records like the Schwab Fundamental U.S. Large Company Index ETF.
- Newcomers like OMFL and IUS are also exciting plays with superior short-term track records. In particular, IUS features an excellent balance of growth, value, and profitability.
- There aren't many significant flaws with PRF, though the lack of a leverage screen could explain recent underperformance. It's a nice factor ETF, but just isn't optimal, so I'm reiterating my hold rating.
Investment Thesis
The Invesco FTSE RAFI US 1000 ETF ( PRF ) remains a solid, albeit relatively expensive, smart-beta fund. By selecting 1,000 U.S. companies based on dividends, free cash flow, sales, and book equity value, PRF avoids mega-cap concentration problems common with market-cap-weighted funds like the iShares Russell 1000 ETF ( IWB ). Still, there are better choices than PRF. FNDX, a factor ETF that adjusts for leverage, has proved superior post-pandemic, and readers of my previous review identified two more ETFs worth pursuing. This fundamentals-focused article compares PRF with four well-diversified ETFs, and although its position has improved since November, it still isn't worth a buy rating.
PRF Overview
Strategy Discussion
PRF tracks the FTSE RAFI US 1000 Index, selecting 1,000 U.S.-listed companies based on four factors: total cash dividends, free cash flow, total sales, and book equity value. These factors mean a bias toward large-cap stocks, but the likelihood of overconcentration in just a few mega-caps is unlikely. For example, Apple (AAPL) scores well in total sales but not so great on the dividend screen. As a result, its weight in PRF is 2.00% compared to 6.15% in the iShares Russell 1000 ETF . You'll find these reweightings throughout, and your decision may be guided simply by how much you believe in mega-cap stocks like Apple, Microsoft ( MSFT ), and Alphabet ( GOOGL ) (GOOG).
I previously wrote about PRF's 0.39% expense ratio, a key drawback for a core holding. At the time, I identified the Schwab Fundamental U.S. Large Company Index ETF ( FNDX ) as a cheaper alternative with nearly identical fundamentals. FNDX has since outperformed by 0.67%, and investors should default to these lower-cost options unless the fundamentals dictate otherwise.
In my previous review, readers suggested I consider the Invesco Russell 1000 Dynamic Multifactor ETF ( OMFL ) and the Invesco RAFI Strategic US ETF ( IUS ). Along with IWB, my upcoming analysis compares the fundamentals for all five funds. PRF is the most established of the factor ETFs, but its expense ratio is also the highest. OMFL and IUS are newer offerings but have competitive fees and, as we'll see next, solid short-term track records.
Performance Analysis
Since IUS launched in September 2018, PRF has underperformed FNDX, OMFL, and IUS by an annualized 1.29%, 3.72%, and 2.22%. During this period, IWB gained 9.08%. All funds had similar standard deviation figures, but PRF had the most significant 26.36% drawdown in Q1 2020. I don't want to hold that against PRF, as that period was unique, and some funds were luckier than others. Still, PRF's post-pandemic performance trailed these peers by 0.5-1.5% per year, so a "this time is different" argument is challenging.
Returning to FNDX's inception in August 2013, PRF gained an annualized 10.62% vs. 11.39% and 11.70% for FNDX and IWB. The two factor ETFs did an excellent job in 2022, effectively offsetting the underperformance in 2020.
It's a terrific illustration of how these ETFs should behave. Assuming you aren't interested in predicting which factors markets will favor each year, relying on multi-factor ETFs reduces risk. It won't work in your favor for some years, but markets tend to reverse irrational market movements. We saw extraordinarily positive market sentiment in the early 2000s, 2009, and 2020-2021. However, fundamentals eventually mattered, and markets favored high-quality companies with lower valuations in 2022.
Still, these annual returns highlight how PRF slightly underperforms FNDX most years. They're highly correlated, but there's something causing PRF to lag. My hunch is it's the lack of financial leverage screen, which FNDX employs. Debt was less of an issue in the early 2010s, but with interest rates off their record lows, investors should pay attention to how companies generate profits. The DuPont Model breaks down a company's ROE ratio into three parts:
- Net profit margin (net income / sales)
- Total asset turnover (sales / total assets)
- Financial leverage (total assets / common equity)
A more accurate assessment of a company's core operations is made by stripping out the financial leverage component. As a result, higher interest rates are a headwind for PRF.
Corporate Finance Institute
This last performance section compares rolling three-year returns for PRF and IWB since January 2006. As shown, PRF spent much of the previous decade trailing. It's only recently that PRF has climbed back, and this makes sense. IWB is more growth-oriented, and growth stocks have lagged value stocks over the last year after outperforming after the Great Financial Crisis. Therefore, owning factor-based ETFs is prudent in this environment. The critical question is if PRF is optimal. For the answer, let's look closer at its composition and fundamentals against the four alternatives.
PRF Analysis
Sector Exposures and Top Ten Holdings
Apple is a top holding with a 2.00% weighting. However, that's small compared to IWB's 6.15% allocation. Other top holdings include Exxon Mobil ( XOM ), Berkshire Hathaway ( BRK.B ) (BRK.A), and JPMorgan Chase ( JPM ). JPM represents the Diversified Banks industry, PRF's top industry with a 5.43% total weighting. In effect, it's a well-diversified portfolio, with the top ten assets totaling 17.62% compared to 24.32% for IWB.
At the sector level, PRF overweights Financials but is otherwise reasonably well-balanced. Readers may appreciate its higher allocation to Energy, an inflation-friendly sector. In addition, PRF is light on Technology stocks, a sector that still carries plenty of risks.
Fundamental Analysis
The following table highlights selected fundamental metrics for PRF's top 25 industries. Also provided are summary metrics for FNDX, OMFL, IUS, and IWB, with my observations to follow.
1. PRF's five-year beta is 1.02, indicating a similar volatility level to FNDX, IUS, and IWB. OMFL is the oddball at 1.26, and I had to double-check to ensure I had the correct data since OMFL's five-year beta in November was 0.85. However, it's accurate, and an archived version of its fund page reveals a drastic change in the portfolio's weighted-average market capitalization. It fell from $437 billion to $10 billion in three months, illustrating just how flexible are the Index rules. Interested readers can click here to read more about the Index, which reconstitutes as frequently as monthly.
2. All factor ETFs have less estimated sales and earnings growth than IWB. Therefore, expect underperformance if we return to an environment where growth stocks are favored. However, slightly less growth for a reasonable valuation discount is appropriate now. PRF trades at 17.38x forward earnings, less than FNDX's 17.91x, and has a higher earnings growth rate (6.88% vs. 6.16%). It's a minor reversal from November, reflecting the underperformance since my article was published.
3. OMFL has moved into deep-value territory and trades at 13.94x forward earnings with a 3.83% estimated earnings growth rate. The model favors valuation factors above all else, and you may consider it a temporary alternative to pure value ETFs like RPV or XMVM. Either way, it's not a direct competitor to PRF anymore, and I'm a bit uneasy about recommending a fund that can change so much so quickly.
4. IUS has a slightly better earnings growth and profitability score than PRF (9.25/10 vs. 8.78/10). As a result, IUS trades at a more expensive forward earnings valuation (19.07x vs. 17.38x). That's the critical difference since the $365 billion market capitalization indicates the portfolio has its fair share of mega-cap stocks. Furthermore, there isn't much difference in EPS Revision Scores (5.26/10 vs. 5.29/10), indicating similar Wall Street sentiment.
Investment Recommendation
Overall, I don't have many negative things to say about PRF. If you were on the fence between PRF and FNDX, PRF might be a better opportunity today due to recent underperformance. However, the differences are slight, and I reiterate that investors should favor lower-cost funds in these situations. Investors may consider the more richly-valued IUS to maintain high quality. It's difficult to argue with its track record since it's outperformed PRF by 2.22% since its September 2018 launch, and it has a cheap 0.19% expense ratio that won't impact long-term returns by much. That's my pick of the five ETFs discussed, and if you have any additional suggestions worth considering, I welcome them in the comments section. Thank you for reading.
For further details see:
PRF: Smart-Beta Showdown - How It Stacks Up Against Its Peers