ETFs: Index Funds Are Still a Good Idea

Don't trust the recent arguments that they do more harm than good

There's been a lot of ballyhoo in recent months over the growing number of actively managed exchange-traded funds (ETFs) that have come to market. The conventional wisdom among financial advisers is that investors should deploy their money using methods that remove emotion from the equation, such as sticking to passive index strategies. Lately. however, some market strategists are saying the wild fluctuations of the current equity environment call for a more active approach to investing, an alternative to sitting idly and watching your retirement nest egg shrivel.

But that flies in the face of volumes of research that have shown 80% of active fund managers underperform the benchmark their funds track.

The allure of ETFs that track an index is that people who don't have a lot of money to put into an array of strategies can buy a stake in a diversified basket of stocks that can be traded easily at a very low cost, The problem with passively managed index funds, as most active ETF managers see it, is that the indexes weight stocks based on their market capitalization rather than on fundamental factors such as earnings growth, cash flow, and value. The index funds thus give greater weight to stocks with higher price-earnings ratios and less weight to undervalued stocks, which makes most indexes vulnerable to sudden market corrections.


There's no consensus on what constitutes active management for ETFs. The U.S. Securities & Exchange Commission, in a March 2008 rule proposal, defined it only as not seeking to track the return of a particular index and instead selecting "securities that are consistent with the ETF's investment objectives and policies." Some financial advisers believe that, as long as a fund applies a model consistently and doesn't change its quantitative strategy according to what the market does, it qualifies as a passive strategy, even if generates higher returns than the benchmark index,

For SPA ETFs, a specialist provider of ETFs based in New York and London, active management means using a rules-based quantitative methodology to analyze and rank 5,400 U.S.-listed companies and to pick stocks for six different portfolios based on 24 factors that focus on potential for earnings growth and low valuations. Among the filters that ensure greater diversity for SPA's MarketGrader 40, 100, and 200 ETFs—which comprise the top-ranking 40, 100, and 200 stocks, respectively—are quotas that limit large- and small-cap stocks to 25% of the portfolio each and mid-caps to 50%. No more than 30% of the holdings can be in any one industry, such as energy, and no more than 15% can be in any one sector within an industry, such as oil producers. Three additional Market Grader ETFs are geared to stocks with large, medium, and small market caps.

Once SPA's computer model chooses the stocks, they are all weighted equally so they have an equal opportunity to outperform. The MarketGrader 40 is rebalanced every quarter by using profits from paring top gainers to beef up on shares of the worst performers and replacing only those stocks that fall below the required ranking. The other five portfoios are rebalanced every six months.


The advantage of choosing stocks according to a rules-based quantitative model is that the model picks the holdings with no human intervention, taking emotion out of the process, says Daniel Freedman, managing director of SPA. However flawed you may think the rules are at any given time, the system forces you to focus on the long-term picture, he says.

"The question is, do you have the [nerve] to top up the companies you see not performing in a way you want them to?" he says. "For a company that has underperformed, eventually the underperformance would be seen by the system and it would be chucked out." The turnover rate is 40% to 60% every time the portfolios are rebalanced, he adds.

In August 2006, when market preference began to shift from small- and mid-cap stocks to large-caps, the Market Grader 40 portfolio was oriented more toward small-caps. "Obviously, you wanted to sell the index down and put it back into large caps, but that wasn't the rule of the index," Freedman says. "When small- and mid-caps rebounded in February 2007, the system moved back to a small-cap bias and because of the discipline of the system produced massive returns."

Year-to-date as of the end of August, the MarketGrader 40 fund had lost 9.97% of its value, vs. a 11.39% decline in the S&P 500 Index. The Market Grader 200 was down 8.83%, and the Market Grader 200 was down 11.76% over the same period.


One challenge in getting people to warm to active ETFs has been a general backlash in the financial industry against quantitative models due to the losses they generated for clients earlier this decade and the view that they're too complicated for most investors to understand, says Freedman. SPA's quant model is entirely company-specific and doesn't include economic, inflation, or trade-weighted inputs, he adds.

Ed McRedmond, senior vice-president of portfolio strategies at Invesco PowerShares in Wheaton, Ill., says money flows into PowerShares ETFs have been slow, with investors adopting more of a wait-and-see approach than they did when the first index ETFs were launched in the 1990s.

Wisdom Tree Investments' (WSDT) foray into active equity ETFs began in June 2006 and stemmed from research showing that, by correcting a flaw in capitalization-weighted indexes, higher returns could be generated over time with less risk. "Once you realize you have a better mousetrap, you want to commercialize it, and commercialize it within the best structure, within ETFs," says Bruce Lavine, president and chief operating officer of Wisdom Tree.

The investment firm offers 41 equity ETFs that sample Wisdom Tree's own indexes, which are weighted based on the size of companies' annual dividend payouts or earnings instead of their market caps. Since the funds are rebalanced just once a year, stocks are removed between rebalancings only if they cancel their dividend, file for bankrutcy, or de-list from a major exchange, says Luciano Siracusano, director of research at Wisdom Tree.


Year-to-date through Aug. 31, Wisdom Tree's domestic ETFs have mostly underperformed their comparable cap-weighted indexes, such as the Russell 3000. That's because of the whipping financial stocks have taken since the credit crisis began a year ago. "When you're in a fundamentally weighted fund in the U.S., more of the weight is tilted toward financials because they pay higher dividends and they had higher earnings last year, and we set our weights once a year," says Siracusano.

The returns on Wisdom Tree's 19 international equity ETFs came much closer to matching the returns of their cap-weighted benchmarks, such as the MSCI EAFE Index, for the first eight months of this year, and 16 of them have outpaced the indexes since inception as of Aug. 31. Siracusano says there's a case to be made for the fundamentally weighted index approach, given how well it has held up in an environment where growth strategies have outperformed value strategies.

The three actively managed equity ETFs that Invesco PowerShares launched this past April only use market capitalization to determine the master list of 3,000 stocks from which each fund picks the 50 stocks with the highest rankings based on earnings, cash flow, and low valuation. In the Active AlphaQ Fund (PQY) and the Active Alpha Multi-Cap Fund (PQZ), the 50 stocks start out equal-weighted, and any stocks that grow to over 2% of the portfolio's total asset value are cut back to 2% each Friday, says David O'Leary, chief investment officer at AER Advisors, which sub-advises the two funds. The funds also dispose of any names whose rankings have fallen due to negative earnings surprises.

"We don't want one stock to dominate and the next day it blows up. The reason for the equal weighting is you never know what's going to blow up," says O'Leary.


To the extent that actively managed funds steer clear of the weakest parts of the market, he believes they can outperform the index, since stock prices tend to track earnings strength. The disadvantage of an index fund such as those based on the S&P 500, for example, is that they hold bad stocks that cannot be removed from the index until they have lost most of their value, he says. The stocks in his portfolios have annual earnings growth of more than 30% and trade at a p-e multiple of around 12.

O'Leary thinks most active fund managers waste a lot of time and energy trying to time the market, which hurts their returns, when they could focus on finding companies with high earnings growth and low valuations.

The four active Alpha ETFs offered by PowerShares have an expense ratio of 0.75%, triple the average fee of most index ETFs and two to three times higher than Wisdom Tree's U.S.-based active ETFs, but half the average fee of the typical actively managed mutual fund.

Lavine at Wisdom Tree believes choosing to be as active as you want using index-based tools is the winning concept. "You get more returns from being in the right asset class than from the stocks you choose within that asset class," he says. "If you chose commodities this year, you did well. If you chose financial stocks, you didn't do so well."

Many professionals, including Lavine, argue that the value you add to a portfolio by getting the asset allocation right far exceeds the differential you get from how active you are in selecting the stocks within that asset class. "ETFs are perfect for that world," he says. "You get a high level of diversification within one trade. They're fabulous tools for being smarter than market downturns."

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