The universe of fundamentally weighted exchange-traded funds was expanded this year by new issues from RevenueShares. Those, of course, featured a set of ETFs weighting all the stocks within the S&P 500, S&P MidCap 400 and S&P SmallCap 600 indexes according to their annual revenues.

In November of this year, two other ETFs were issued. Those were the RevenueShares ADR Fund and the RevenueShares Financials Sector Fund. Again, revenue is the only item used in the RevenueShares weighting methodology.

A Different Sort Of Process

Among alternatively weighted ETFs, RevenueShares employs a unique method. Its ETFs do not follow a fundamentally weighted index, but instead reallocate previously existing indexes by Standard & Poor's utilizing all of the stocks within the index.

For example, the RevenueShares Large Cap Fund creates the ETF by taking the revenue from each company within the S&P 500 and dividing by the total revenue of the S&P 500 to get each stock's weight within the ETF.

This is different from other fundamentally weighted ETFs that use a fundamental methodology to screen for stocks in a systematic way, creating an index weighted heaviest with stocks strongest in the fundamental characteristics. RevenueShares merely reallocates index constituents.

By reweighting the S&P 500 Index, RevenueShares Large Cap Fund (NYSEArca: RWL) can be easily compared with other S&P 500 Index funds, and the excess return, or lack thereof, can more likely be attributed to the methodology since the funds represent an alternative to a very popular index, tracking the same universe of stocks.

Below are three graphs illustrating the return of the RevenueShares ETF to a comparable ETF tracking the same benchmark index. The graphs all begin on Feb. 21, the inception date of the three funds.

Clearly the performance of the three original RevenueShares ETFs is nothing to brag about. Each has under-performed the benchmark index. Performance closely tracking the index benchmark can be expected, since all stock constituents are included but only reallocated. In theory, according to RevenueShares, revenue being a "top-line item" is less prone to manipulation and therefore is a better judge for setting index weights.

Backtested Data

Like all other fundamentally weighted indexes and ETFs, providing backtested returns against a traditional index seems to be key in proving the benefit of the fundamental methodology. Below is a year-by-year breakdown of the backtested returns provided by RevenueShares' website for RWL.

Of course this data is hypothetical and represents backward-looking returns. Investors need to take a hard look at this kind of data, since the first nine months the fund was available in 2008, it under-performed the S&P 500. According to the backtested performance, it was the first time it has under-performed in eight years.

The concern and risk is revenue weighting only gave excess returns over a short historical time period and will not continue to do so in the future.

Other successful ETFs have strong research and academic theory backing why the fundamental screens used by the indexes are a better way to value and choose stocks to solve the problem of overweighting higher-priced stocks that traditional indexes are prone to doing. At first glance, revenue does not seem an adequate method to value a stock within an index, being biased only toward companies strong in sales, taking no account of size or earnings. Wal-Mart is, of course, the largest component within the Large Cap Fund. However, revenue as a single measure does solve very simply the tendency for traditional indexes to overweight higher-priced stocks

Is Revenue Shortsighted?

A main concern for investors when considering RevenueShares ETFs is, firstly, how they view the capital markets. RevenueShares endorses revenue as free from accounting manipulation and a good indicator of a company's strength, making it perfect for weighting an index. The ETFs rebalance using this method annually. According to this methodology, revenue represents a company's relative strength and resilience.

Each RevenueShares ETF has a spectacular hypothetically backtested model, beating its benchmark index by a considerable amount annually. The problem is, it is unclear why revenue was chosen, since there is limited research showing that sales alone is a worthy measure for a company's health and future growth. Investors will never know if the revenue methodology was chosen because of sound theory or because of data mining. If the methodology was developed from the data mining of many single factors uncovering revenue as an optimal trait over the last several years, can it be trustworthy and expected to outperform in the future?

Revenue and sales discriminate against smaller profitable companies. RevenueShares will forever be biased toward companies that operate in high gross sales businesses, like Wal-Mart and Exxon Mobil. The Large Cap fund most noticeably lacks a strong holding with information technology, holding nearly half the allocation as the S&P 500.

The bar charts above show the RevenueShares Large Cap Fund had the most excess return as the Tech bubble fell apart. This may be a characteristic of RevenueShares—underweighting companies with outlandish expected return reflected in their price-to-earnings but very little current sales.

As of this year, consumer staples and consumer discretionary made up 16.77% and 15.25%, respectively, of RWL, showing the tendency to overweight mature companies with high current sales while underweighting companies with higher expected return and lower current sales. This method would, again, be a good defensive play against bubbles.

Since RevenueShares ETFs do not take into account any market prices, they should be immune to wild overvaluations during bubbles. However, 2008 was nothing like the tech bubble, and RevenueShares ETFs overweight companies with high gross sales. For example, Ford is the fourth-largest allocation of the Large Cap Fund ETF, a stock down more than 60% this year.

Kyle Waller is a research analyst at Wiser Wealth Management in Marietta, Ga. He welcomes comments and suggestions for future columns at: This e-mail address is being protected from spambots. You need JavaScript enabled to view it .