Exchange-traded funds have a new weapon in their fight against actively managed stock mutual funds. It's the strategy-based ETF.
Instead of tracking indexes that give a window on a market, industry or class of stocks, strategy-based ETFs focus on indexes that use various factors to identify promising stocks not unlike the way an active manager might use those same criteria.
Russell Investments is one of several investment firms now offering strategy-based ETFs. According to Mark Roberts, head of research at Russell Investments, the company's Investment Discipline ETFs are an attempt to evaluate "what an active manager might consider when selecting stocks," without the human weaknesses that can influence trading decisions, like favoritism or style drift.
Offered predominantly by Russell Investments, Guggenheim Partners LLC, Invesco (IVZ) Ltd.
Here are key questions that potential investors should ask:
What is the strategy?
The first strategy-based ETFs were designed to identify promising high-dividend stocks or to incorporate "technical analysis" in their methodologies, such as by favoring the stocks in an index that have been advancing most strongly. More recently, Russell Investments and QuantShares, a group of funds from Boston-based investment advisers FFCM LLC, have homed in on other measures including the volatility of an individual stock in relation to the market, and what constitutes "growth" or "value" stocks.
For example, Russell Equity Income (EQIN)
Like all index-based ETFs, the strategy of the index will be detailed on the product fact sheet, prospectus and reports. The rules and standards of the index will either be linked to by the ETF provider or available from the index firm. In some cases, as with this Russell product, the index provider may be an affiliate of the ETF sponsor. If investors think that is too cozy a relationship, they may want to see if another ETF and/or index provider offers a similar strategy.
How does this strategy fit into my portfolio?
Strategy-based ETFs can be a tough fit for traditional index investors or advisers who use index-based ETFs to construct portfolios. These ETFs are largely geared to attract investors who prefer the styles and theories espoused by many active managers, but without the whims of human decisions.
How much to allocate to a strategy-based ETF depends on your own investment style. If you believe share buybacks are an indicator of corporate strength, you might consider PowerShares Buyback Achievers (PKW)
What is the appropriate benchmark?
Because these ETFs are based on an index, you can start evaluating a fund's performance by looking at the index itself. Even though many of the indexes were built specifically for the ETF, the ETFs may have a surprising tracking error due to fluctuations from ETF trading. Some of the ETFs also have some flexibility to vary their holdings from the index.
Tom Lydon, editor of website ETFtrends.com, suggests that investors monitor the ETF for a while to make sure that it actually follows through on what the strategy dictates.
For its funds, iShares offers both tracking-error and premium/discount data on its website. Strategy-based products from iShares, a unit of BlackRock (BLK) Inc.,
After seeing how well the ETF tracks its own benchmark, the ETF can be benchmarked against a category average appropriate for the size (large-cap, small-cap) and style (growth, value) of the fund's stock holdings.
How actively does the strategy rebalance?
For strategies based on relative valuation metrics, earnings forecasts or even volatility, how often the index and ETF reconstitute can be important for capturing the return on securities as they pass into the screen. Some indexes are reconstituted as frequently as monthly, others quarterly or semiannually, and some only yearly. Indexes also rebalance frequently as well. Rebalancing, unlike reconstitution, adds or subtracts shares proportionately to get back to the index's defined rules.
Just like overall portfolio rebalancing schedules, index rebalancing should be geared toward taking advantage of opportunities in a dynamic market while also minimizing turnover. Generally, index providers test for optimal rebalancing periods when constructing a new index. Only in extraordinary circumstances are index rules reconsidered.
"Consistency in the rules and taking the emotion out of the product is key to a successful index strategy," says Adam Patti, chief executive of IndexIQ.
With the frequent portfolio changes made by these ETFs, one might think they would lose some of their tax efficiency. This is not the case, so far. Like other ETFs, these funds can use shares that no longer fit the ETF's mandate to pay institutional investors who redeem their ETF shares. That minimizes actual sales of appreciated stocks and thus limits capital-gains distributions for the ETF's investors.
Is the strategy worth the higher cost?
This depends on where you prefer to take your costs. Most strategy-based ETFs tend to have higher expense ratios than standard index and sector ETFs, but far lower expenses than actively managed stock funds. As with any exchange-traded product, you may have to pay a commission each time you buy, whereas mutual funds generally have higher expense ratios.
For example, the $7.3 billion SPDR S&P Dividend (SDY)
Mr. Weinberg is an editor for
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