A few days ago, I argued that we needed foreign-indexes whose inclusion criteria and weighting scheme are tied to economic substance (i.e., where revenue/profit is earned) rather than where a firm is domiciled.
As if on cue, a firm named VTL Associates (which, if I'm not mistaken, is an investment consultant) amended its registration statement for three ETFs that weight stocks based on revenue. Unfortunately, all three will track domestic benchmarks. Alas, the wait continues, hopes dashed.
The filing is noteworthy in one respect, however: These three 'RevenueShares' ETFs appear to suffer from the same malady that afflicts so many of the quasi-active or 'fundamentally-weighted' funds on the market: expensus inflatus. They're too darn pricey!
Consider -- RevenueShares Large Cap will re-weight the securities in the S&P 500 index by revenue, reconstituting annually. Pretty straightforward, I guess, and I'm sure the strategy backtests reasonably well (not that that means anything). The cost? 0.49%, or seven times what it costs to own the SPDR. That same story holds more-or-less true for RevenueShares Mid Cap (which will reweight the S&P Mid Cap 400 Index by revenue) and RevenueShares Small Cap (which will reweight the S&P Small Cap 600), which will cost 0.54% apiece, or nearly two-and-a-half times what you'd pay to own iShares S&P Mid Cap 400 or iShares S&P Small Cap 600. In case you're wondering, the RevenueShares expense ratios are explained almost entirely by the management fee each fund will levy (0.45% for large-cap, 0.50% for mid- and small-cap; no breakpoints, so the fee isn't set to fall as assets rise; nice).
Now I understand an indexer's desire to be paid an amount commensurate with the value it's adding or the, shall we say, 'distinctiveness' of the service it's providing. But seven times more than the SPDR? When you're reconstituting the index once a year? When your approach will not soon be compared to splitting the atom? That's a huge stretch. (I'm going to go out on a limb and guess that the Pennsylvania Treasury System didn't pay anywere near 0.49% when it allocated a portion of that state's investment fund to an account that tracked the large-cap revenue-weighted index. Call me crazy.)
Yes, Rydex charges 0.40% for its ETF that equal-weights the S&P. No, that doesn't make it right, as I'm not at all convinced that an equal-weighting scheme is worth five times a conventional market-cap weighted approach. Yet that's what they're asking investors to pony up.
What impresses me about WisdomTree is that while the firm is charging a premium for its products, which track fundamentally-weighted indexes, it isn't gouging investors. That seems like a far more-prudent tack from a business standpoint than simply assuming that the market will discern the very subtle differences that separate your 'fundamental' or 'quasi-active' approach from the others out there, cry 'eureka', and belly-up to pay upwards of 50 basis points for the pleasure. (Also, it comports far better with the stated objective of fundamental-indexing, which has never been predicated on instant-gratification; that is, these approaches seem to lend themselves to strategic or tactical portfolio allocations, contexts in which expenses loom very large; that fact appears not to have been lost on WisdomTree.) That's why when I see products like RevenueShares, merits notwithstanding, levying irrationally high expense ratios, I can only shake my head: This will not work.
The irony is that once these products make their debut and we get portfolios, we're likely to think they're attractive from a valuation standpoint. For instance, when I revenue-weighted the S&P as of 1/31/08 (an exercise that took around, oh, five minutes to perform using trailing twelve month revenue data in our database...sigh...), I found that the resulting portfolio was trading at a hefty 17% discount to what our analysts think it's worth in aggregate, which slightly exceeds the 15% discount SPY was trading at as of Feb. 13. That works out to roughly 1% per annum in incremental expected annualized returns. But you're paying an extra 42 basis points to invest in RevenueShares Large-Cap, which would make any incremental expected return de minimis. So, we'd have a hard time getting fired up about the fund from a valuation standpoint when other comparable, lower-priced alternatives beckon.
And it goes without saying that we'd probably never recommend products like these as potential portfolio building blocks. They're simply too expensive. Perhaps the advisor will sharpen its pencil and cut the fees (you would think the thought had crossed VTL's mind, what with Claymore poised to liquidate 11 ETFs from its line-up, a number of which were quasi-active products). For now we can only hope.
Jeff Ptak
Morningstar, Inc.