As the ETF industry continues to develop, many investors have begun to move away from the more traditional funds in favor of ETFs that employ unique methodologies that are aimed at delivering potentially higher returns. Of the most noteworthy and popularinnovationshas been the development of alternativeweightingstrategies, specifically the RAFI methodology . Several years ago, Research Affiliates, a global lead in innovative investing and asset allocation strategies, developed the fundamentally-weighted indexes that utilize the RAFI methodology. Now there are nearly 20 different exchange-traded products that are linked to RAFI-weighted indexes. But before taking a look at the performance of these popular funds, a fundamental understanding of the unique methodology is essential.

Understanding RAFI

The RAFI weighting methodology is relatively straightforward. While traditional cap-weighted indexes determine allocations based on marketcapitalization, RAFI funds take into account several fundamental factors to determine the weighting of an individual holding. These factors include cash flow, book value, sales and dividends .

The primary criticism of market capitalization weighted indexes is that there is a direct relationship between stock price and the weighting assigned. The RAFI methodology's goal is to effectively break the link between share price and weight within an index. And while cap-weighting features a number of potential advantages-such as low cost and maintenance-their noteworthy drawbacks warrant investors to perhaps take a look alternative strategies, such as RAFI. For example, cap-weighted methodologies tend tooverweightovervalued stocks and underweight undervalued ones, which can obviously create a potential drag on returns.

A look at the performance of these fundamentally-weighted ETFs in comparison to their cap-weighted counterpartshighlightsthe impact ofweighting methodologies on bottom line returns .

How Do RAFI ETFs Stack Up YTD?

Ticker RAFI Index RAFI ETF YTD Cap-Weighted Index Cap-Weighted Index YTD
PRF FTSE RAFI 1000 15.36% Russell 1000 Index 16.28%
PXF FTSE RAFI Developed Markets ex-U.S. 10.61% MSCI EAFE Index 9.48%
PAF FTSE RAFI Asia Pacific ex-Japan 17.38% MSCI AC Asia Pacific ex-Japan 13.21%
PXH FTSE RAFI Emerging Markets 9.05% MSCI Emerging Markets 9.92%
PDN FTSE RAFI Developed ex-U.S. Small-Mid 10.31% MSCI EAFE Small Cap 12.66%
PRFZ FTSE RAFI U.S. 1500 Small-Mid 12.19% Russell 2000 14.23%
*Year-to-date returns as of 10/22/2012

Out of six Powershares RAFI ETFs, only two funds have outperformed their corresponding cap-weighted indexes; the FTSE RAFI Developed Markets ex-U.S. (PXF) and FTSE RAFI Asia Pacific ex-Japan (PAF) ETFs. TheunderperformingRAFI ETFs do not, however, trail far behind their cap-weighted competitors. But for those cost-consciousinvestors, the high price tag on these ETFs, which average around 0.75% to 0.8%, may not be worth it since only a few have proven that the RAFI methodology trumpstraditionally-weighted indexes.

Value YTD Core YTD Growth YTD
Large Fundamental Pure Large Value Portfolio (PXLV) 16.27% Fundamental Pure Large Core Portfolio (PXLC) 13.55% Fundamental Pure Large Growth Portfolio (PXLG) 18.05%
Mid Fundamental Pure Mid Value Portfolio (PXMV) 15.64% Fundamental Pure Mid Core Portfolio (PXMC) 9.89% Fundamental Pure Mid Growth Portfolio (PXMG) 9.40%
Small Fundamental Pure Small Value Portfolio (PXSV) 14.28% Fundamental Pure Small Core Portfolio (PXSC) 9.29% Fundamental Pure Small Growth Portfolio (PXSG) 10.26%
*Year-to-date returns as of 10/22/2012

PowerShares' lineup of value, core and growth Fundamental Pure ETFs have certainly raised the bar in 2012, delivering double digit year-to-date returns. Of the lot, the large-cap focused funds have all outperformed their mid and small-cap counterparts across all three investment styles. Thus far in 2012, the biggest winner has been theRAFI Fundamental Pure Large Growth Portfolio (PXLG) with its whopping 18.05% year-to-date return .

Ticker ETF YTD
PHB Fundamental High Yield Corporate Bond Portfolio 8.64%
PFIG Fundamental Investment Grade Corporate Bond Portfolio 5.21%
*Year-to-date returns as of 10/22/2012

For those looking for fixed income exposure, perhaps the RAFI methodology is not the best option, as year-to-date returns aresignificantlylagging in comparison to other funds in PHB's and PFIG's respective categories.

While the fundamentally-weighted PHB does offer a relatively handsome 8.92% return, the comparableSPDR Barclays Capital High Yield Bond ETF has logged in gains of 11.02% thus far in 2012. And in regards to PFIG, the ultra populariBoxx $ Investment Grade Corporate Bond Fund has delivered year-to-date returns of 10.95%, nearly double that of PFIG's .

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Disclosure: No positions at time of writing.

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