Market cap stock weighting has been around ever since the introduction of the S&P 500 Index nearly 60 years ago. But is price weighting really the most effective way to capture higher returns? These days we’re hearing a lot about “smart beta” alternatives to market cap. We believe we have found the smartest of smart beta strategies—revenue weighting.

There’s no lack of smart beta strategies in the market today. You can weight each stock equally. You can weight them on fundamentals, such as cash flow, earnings, or dividends. You can weight on single factors that drive returns, like low volatility or price momentum, or you can weight using combinations of factors.

Watch video: investor education: intro to smart beta strategy, revenue weighting

But at OppenheimerFunds, we believe using the fundamental weighting strategy of revenues offers a number of appealing benefits. In 2015, we acquired VTL Associates, which has a proprietary method for weighting index companies by their revenues, and it holds exclusive rights with Standard & Poor’s to offer investments based on a revenue-weighted index.

Head of Beta Solutions Sharon French explains that taking price out of the equation helps the revenue-weighted portfolio avoid the unintended risk that occurs when a particular stock or sector becomes overvalued. Since revenues don’t tend to fluctuate as widely as prices, revenue also provides more stable sector exposure than market capitalization.

As French says, “Every company also has revenues. So you still get full, diversified exposure to the broad market.” That isn’t the case with some other fundamentals, like dividends. Not every company pays dividends. “Using revenue also creates a lower valued portfolio—a benefit, given that value is another one of the proven factors for driving long-term equity returns,” says French.

“Employing revenue as a weighting strategy also makes good sense because the price-to-sales ratio has proven to be one of the strongest indicators of future returns. We have found consistent outperformance across small-, mid- and large-cap stocks over long periods.”

Revenue weighting isn’t perfect, and will not outperform in every short-term market environment. No strategy will. For investors, what’s important is to know the conditions in which a strategy will outperform and underperform. Revenue weighting tends to underperform in growth-oriented and narrowing markets, the latter occurring when a few stocks or one sector takes off like a rocket. “But history shows that over the long term you tend to give those gains back, and then some,” says French.

“I’m a value investor through-and-through, and I think a majority of people are,” says French. “Given these funds’ value-orientation, I think there are considerable merits to having a portion of an investor’s core portfolio allocated to a long-term revenue-weighted strategy.”

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