With more and more advisers and institutional investors embracing smart beta strategies, the universe of fundamentally-weighted exchange traded funds (ETFs) is rapidly growing.
One potential pitfall of smart beta’s exponential growth is the dizzying variety of strategies coming to market, making it potentially cumbersome for advisers to stay abreast of all the newest concepts while also remaining focused on some alternatively-weighted methodologies that have already proven durable.
Revenue weighting is an example of an alternative to traditional market capitalization weighting that not only has a long-term track record, but is easy to comprehend and deploy within client portfolios. For example, the S&P 500 Revenue-Weighted Index was launched at the end of 20051, meaning it is battle-tested as it was around during the dark days of the global financial crisis.
Again, revenue-weighted indexes and funds are straight forward. The S&P 500 Revenue-Weighted Index is comprised of the S&P 500 member firms weighted by top-line revenue, not market value, which is the weighting methodology for the standard S&P 500 and related funds. As the chart below confirms, revenue weighting has a solid long-term track record.
Advantages of Revenue Weighting
Using the S&P 500 Revenue-Weighted Index as our “bogey” here, there are some notable advantages with weighting stocks by top-line revenue. One example is reduced concentration risk. Currently, the top 10 holdings in the S&P 500 Revenue-Weighted Index combine for about 17.60% of the benchmark’s weight. In the cap-weighted S&P 500, that number jumps to 21.76% (as of July 23).
On a related note, there are significant sector-level differences between revenue-weighted and cap-weighted benchmarks. The three largest sector weights in the cap-weighted S&P 500 – technology, financial services and healthcare – combine for 54.77% (as of July 23) of that index’s weight. Conversely, the top three sector exposures in the S&P 500 Revenue-Weighted Index – healthcare, consumer discretionary and consumer staples – combine for 46.20% of that index.
Results of these redistributions include a value tilt for revenue-weighted funds.2 In fact, Morningstar classifies the S&P 500 Revenue-Weighted Index as a large-cap value index as its earnings multiples usually trade more inline with designated value indexes and at discounts to the cap-weighted S&P 500.
Related: Refreshing The Value Proposition
With valuations on broad, cap-weighted domestic equity benchmark looking a tad stretched, weighting stocks by revenue not only provides increased diversification, but reduced exposure to sectors that are potentially richly valued.
With traditional ETFs, rebalancing occurs two to four times per year and usually means no more than resetting a fund so that comes back inline with predetermined sector weights or caps on individual securities’ weights. When it comes to revenue-weighted indexes, the rebalancing process provides an opportunity to carry out one of investing’s most famous lessons: buy low and sell high.
Additionally, revenue-weighted strategies offer out-performance potential in slower moving bull markets and the possibility of reduced volatility along with lower drawdowns when the growth factor is in favor.
1 Source: S&P Dow Jones Indices https://www.spindices.com/indices/strategy/sp-500-revenue-weighted-index
2 Source: Nasdaq May 16, 2017 https://www.nasdaq.com/article/measuring-the-efficiency-of-revenue-weighted-etfs-cm790009
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