By Samuel Lee
The exchange-traded funds rolling out these days aren't the
quintessential index funds of yesteryear but are often active
strategies themselves. Many are seductive--who doesn't want more
yield or lower volatility? You might have plumped money in one
yourself. Or you may have held off buying a newer strategy ETF, and
for good reason. They're a bit trickier to understand, charge a lot
more, have limited histories, and often have that whiff of
faddishness. Experienced hand or not, you'd probably feel more
comfortable with a framework for understanding more-complex funds.
As a starting point, think of picking a strategy as very much like
being an active manager. Indeed, many hedge funds earn their keep
by simply rotating among and blending well-known strategies. The
market is hard to beat (isn't that why we like ETFs?), so expect
assessing strategies to be hard work.
The first question to be asked of any strategy ETF: How does it
make money? If you're buying a strategy in the hopes of earning
market-beating returns, you better have a very good reason to
justify your belief. The ETF providers sure don't. If they did,
they'd quit the ETF industry, open up hedge funds, leverage their
ideas to the hilt, and mint money. In other words, their
comparative advantage is in selling products, not developing
cutting-edge investing ideas. So what if the ETF came out with
shiny brochures and eye-popping back-tested returns? The very
existence of a supposedly market-beating strategy in an ETF should
make you wary: The strategy is often 1) repackaged risk; 2) not
very well supported with theory or data; or 3) overcrowded. You
want a good, intuitive story as to why a strategy will continue to
create excess profits, despite everyone knowing about it.
Where's the Theory?
Theory, which makes disprovable predictions, separates science from
voodoo. Simple cause-and-effect stories don't cut it. Ideally, a
theory should have been vetted by multiple independent and credible
researchers. A theory should make predictions that later research
confirms. You might find that level of rigor is too harsh for
vetting an ETF. But if no hard thinking were required to pick a
good strategy, we'd all be fabulously wealthy.
A good theory has several features. It's intuitive. It has
mounds of supportive data. And it's persuasive, cohering with other
features of the world that you're familiar with. Two of the most
well-known properties of financial markets have ample theory and
data backing them:
Momentum, or the tendency for prices to trend, has been found in
virtually every market studied. It likely arises from cycles of
investor underreaction and overreaction, and the tendency to herd.
This story is well-supported by experimental data. Momentum
persists because shorting it is very dangerous to arbitrageurs, who
risk getting wiped out (value-manager GMO almost died in the late
90s betting against the tech bubble). In fact, rational investors
may hop onto trends, strengthening them. Unfortunately, there are
few good momentum products out there. Russell has several very
low-cost momentum ETFs, though they haven't gathered much in the
way of assets.
Value, or the tendency for stocks cheap by fundamental
accounting metrics to outperform stocks expensive by such metrics,
owes much to investors overreacting to bad news. However, value
stocks also tend to exhibit negative momentum, meaning it may be
profitable for arbitrageurs to short-sell value stocks in the short
run. As with momentum, value can be dangerous to arbitrageurs.
Traditional value indexes and dividend strategies all load up on
the value factor, so good ETFs abound.
In many cases, strategy ETFs repackage well-known "risk" factors
(called such by convention, though no added risk may be involved)
associated with higher returns, such as size, value, and momentum.
One of the most popular alternate-weighting ETFs, Guggenheim
S&P 500 Equal Weight (
), equal-weights S&P 500 stocks and rebalances quarterly. It
has handily beaten the S&P 500 since its 2003 inception.
However, once you credit back its systematic mid-cap overweighting
and tiny value tilt, it's actually generated zero outperformance
over that period. You could've paid less for a mid-cap ETF and
gotten the same performance. Historical simulations of
equal-weighting covering multidecade spans and international stocks
have shown zero value added after controlling for size and value
click to enlarge
source: Morningstar Analysts
Where's the Data?
Neither Guggenheim nor S&P have published high-quality research
on the equal-weight strategy. For that, I had to turn to the
academic literature. Investors are often wholly dependent on the
inadequate materials put out by providers, a state of affairs
possible because many are content to draw erroneous conclusions
from just a few years of returns or low-quality research. Properly
analyzing a strategy requires properly analyzing data. And a few
years of returns isn't going to cut it. Not even a decade, most
likely. The markets have a huge component of randomness. Coming to
a well-reasoned, sound conclusion on a strategy often requires
testing it on many decades of history, and not just in the U.S., in
order to rule out chance.
For example, dividend strategies have been tested in many
markets, to good effect. London Business School professors Elroy
Dimson, Paul Marsh, and Mike Staunton have found above-average
risk-adjusted returns for high-yield stocks with 110 years of U.K.
stock market data, 84 years of U.S. data, and at least 19 more
markets with at least 25 years of data. Dividend stocks have beaten
the benchmarks in almost every market studied, and their returns
aren't just from a few anomalous periods, but persist throughout
the decades. WisdomTree's ETFs, like WisdomTree LargeCap Dividend (
), are built on exploiting this phenomenon. To be fair, dividend
strategies are often just repackaged value tilts, though they may
be much purer than what you could get with a conventional value
Of course, even if a strategy passes this test, it's no slam
The problem with exploiting a rigorously tested strategy is that
many others have the same idea. Strategies can and often do become
overcrowded. There's no good public data on when a strategy gets
overcrowded, so you'll have to make reasoned guesses on whether a
strategy is or isn't in vogue. One metric to assess is a strategy's
capacity is the liquidity of its underlying holdings. Another is
whether every investor under the sun, especially institutions, is
enthusiastic about it. Think long-only commodity futures indexes
circa 2007 or managed futures now. However, if you've done your
homework, you'll have a lot more conviction in the strategy and the
fortitude to stick to it when everyone else is rushing for the
What Passes This Test?
Aside from value and momentum, there are few other strategies that
offer reasonable expectation of excess returns. Of the recent crop
of strategy ETFs, low-volatility ones are the most promising.
Over long periods, low-volatility strategies have outperformed
high-volatility strategies on risk-adjusted bases. As with the
value and momentum effects, it's been found everywhere. Granted,
low volatility overlaps a bit with value. It probably works due to
benchmark-hugging by active managers everywhere, and
lottery-seeking tendencies among investors. Our favorite
low-volatility ETF is PowerShares S&P 500 Low Volatility ETF (
). Unfortunately, this strategy is showing some signs of
overcrowding. Low-volatility sectors, such as utilities, are
trading at historically high valuations. Institutions are now
keenly looking at managing their risks, whether through defensive
equities or risk-weighted (risk parity) strategies. However, over
the long run, the factors that have led to low volatility's
outperformance (benchmark-hugging managers and lottery-seeking
behavior) look set to continue.
A good sniff-test is whether you'd be OK sticking with a
strategy for the next 20 years. If not, chances are the data
haven't persuaded you.
An Ode to Skepticism
Analyzing the market and strategies is necessarily an exercise in
playing the odds. No strategy will work all the time, and no way of
picking strategies will be foolproof. A skeptical, scientific
mindset will tilt the odds in your favor. When that rare good idea
comes along, you'll have the conviction to stick with it during the
inevitable (sometimes decade-long) bad spells. You'll need every
advantage to get, because you're now a portfolio manager.
A version of this article first appeared in the August 2011
issue of Morningstar ETFInvestor.
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
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