The quest to generate alpha is one that is constantly evolving in the ETF industry. Fund providers are consistently creating unique indexes designed to access a subset of stocks that they believe will provide a measure of outperformance versus the broader market. These groupings can include momentum stocks, low volatility strategies, high beta companies, or even hedge fund clones.
Many of these individual strategies have been back tested versus a primary benchmark to provide investors reassurance that their methods have produced superior historical results. However, alpha-seeking ETFs are typically only designed to shine when the market winds favor their specific niche. That is why it is worthwhile to check in on these ETFs in different market environments to see how they react under a specific set of circumstances.
Hedge Fund or Guru Strategy
Retail investors have long been fascinated about where hedge funds and institutional players place their bets in the market. With the Global X Guru ETF (GURU) and AlphaClone Alternative Alpha ETF (ALFA), you get access to two ETFs that filter 13-F filings of the hedge fund universe to assemble a portfolio of favored positions. These ETFs have relatively concentrated portfolios, with GURU allocating an equal amount to 50 stocks and ALFA containing approximately 80 names.
Both ETFs have struggled to meet the returns of the broader market this year and are currently sitting on meager 3% gains in 2014. For comparison’s sake, the SPDR S&P 500 ETF (SPY) has gained 7% over the same time frame.
The majority of that underperformance is likely due to a lack of exposure in the utility and energy sectors, which are this year’s top performers. However, in 2013 GURU added a significant measure of outperformance over SPY with gains of 49.33%. ALFA was able to notch a total return of 39.56% last year as well.
Selecting stocks based on recent momentum is another way to try and outperform a passive benchmark. The PowerShares DWA Momentum Portfolio (PDP) and iShares MSCI USA Momentum Factor ETF (MTUM) are two examples of ETFs that strive to accomplish this goal.
PDP is constructed of 100 large and mid-cap holdings that are outperforming their peers according to a proprietary model developed by Dorsey, Wright & Associates. MTUM, on the other hand, provides exposure to 125 stocks based on a momentum scoring system.
The largest sector allocation in PDP is a 29% allocation to consumer discretionary stocks, while MTUM currently has 23% of its portfolio in health care companies. Despite their vastly different makeup, both ETFs have produced a similar 6% gain in 2014 and are only slightly trailing the broader market.
Low Volatility Strategy
More conservative investors may be attracted to a low volatility strategy that seeks to select stocks with smaller price fluctuations than their peers. This type of ETF would likely outperform in a down market, but still has the ability to add value in a bullish phase as well.
Two competing ETFs in this space are the PowerShares S&P 500 Low Volatility Portfolio (SPLV) and iShares MSCI U.S. Minimum Volatility ETF (USMV). SPLV is constructed of the 100 lowest volatility stocks in the S&P 500 Index and has benefitted from a 23% allocation to the utility sector in 2014. This unique portfolio makeup has produced year-to-date gains of 8.36%.
USMV has a slightly broader makeup of 125 stocks and overweight allocation to health care and consumer staples companies. So far this year, this ETF has produced a respectable total return of 5.89%
High Beta Strategy
The PowerShares S&P 500 High Beta Portfolio (SPHB) is constructed of 100 stocks with above average price movement in an attempt to gain a bias towards greater returns. SPHB is primarily constructed of financial and consumer discretionary companies and has produced the best returns of these alpha-seeking ETFs in 2014. So far this year, SPHB has gained 8.63% and posted a total return of 44.46% in 2013 as well.
Clearly the appetite for high beta stocks has yet to cool down and this index has been in the sweet spot for well over a year now.
Providing a consistent measure of alpha over a long period of time is difficult given the pressure to always be in the right place at the right time. In addition, picking the wrong strategy can lead to underperformance that negatively impacts total return.
However, several of these funds have proven that they can enhance a sophisticated ETF growth portfolio under favorable circumstances. The key to selecting an index that is right for you is to closely monitor the underlying holdings, portfolio weighting methodology, and risk characteristics to ensure the fund meets your individual needs.
Note: The author is long USMV at the time this article was posted.