ETFs: Which Strategy Makes Sense in a Volatile Market?

It's not easy these days to find anyone who's bullish on equities. It's not just that the broad U.S. stock market dropped 10 percent in the second quarter. The flow of disheartening data on jobs, home sales, retail sales, and consumer sentiment in recent weeks has seriously eroded investor confidence.

To the extent that investors want to stick with higher-yielding—and necessarily higher-risk—assets, exchange-traded funds and notes (collectively, ETFs) may be their best bet, some believe. They are an ideal vehicle to achieve diversification across broad indexes as a hedge against elevated market volatility, according to David Elan, a principal at Windward Investment Management in Boston.

"It may mean holding a fair amount of cash in your portfolio," via either short-term U.S. Treasury notes or Treasury Inflation-Protected Securities (TIPS) in an ETF format, he says. "The advantage would be if you decide you want to change your allocation very quickly—if you're using mutual funds, you're subject to a short-term redemption fee and that wouldn't be the case with ETFs." He adds that ETFs may also be the best way to hold gold or other commodities in your portfolio as a hedge against volatility, in lieu of longer-dated Treasury bonds.

Wider Choice

Until a couple of years ago, you would use ETFs because you believed it was extremely hard, if not impossible, to consistently outperform the market and, as a result, paying anything more than minimal fees lowered your total returns. The tax efficiency inherent in ETFs was a nice bonus that would also enhance your returns. Now there's a wider spectrum of choices within the ETF universe.

The traditional ETF simply tracks a chosen underlying benchmark index—like the Standard & Poor's 500-stock index for large caps or the Russell 2000 index for small caps—and replicates the market-capitalization weighting within the index. If you like this kind of ETF, you tend to believe that the market is an efficient pricing mechanism and that stocks are mostly fairly valued.

Over the last five years, the S&P 500 has beaten 60.8 percent of actively managed large-cap U.S. equity funds, while the S&P MidCap 400 index has outperformed 77.2 percent of mid-cap funds and the S&P SmallCap 600 index has outperformed 66.6 percent of small-cap funds, according to the latest Standard & Poor's Indices Versus Active Funds Scorecard, released in March 2010. The results for active managers are better or worse when comparing performance by fund style. The S&P 500 Growth index beat 76.9 percent of all large-cap growth funds and the S&P 600 SmallCap Growth index outpaced 77.8 percent of small-cap funds over the past five years. Value funds fared better, with the S&P 500 Value index beating just 38.8 percent of large-cap value funds and the S&P 600 Value index beating 48.8 percent of small-cap value funds.

But these days, market cap isn't the only game in town. Strictly speaking, ETFs that use weighting systems other than market cap are not actively managed. Fundamentally weighted ETFs—which use criteria such as revenue, dividends, or earnings in composing the portfolio—"are expressing an opinion about the market one way or another that's different than the pure market-cap weighting," says Dave Nadig, director of research at, a fund information website. It's fair to call such products "alpha seeking" since they're trying to beat a market-weighted index, but they're still considered passively managed because they follow a rule book, he says.

RevenueShares Funds

Paoli (Pa.)-based asset manager RevenueShares offers six funds, each of which passively tracks an index but rebalances once a year based on revenue weight instead of market-cap weight. The Revenue Weighted Large Cap Index's top 10 holdings currently include just five of the top 10 names in the S&P 500 as ranked by market cap. Wal-Mart (WMT), the biggest contributor to the S&P 500's total revenue at 4.74 percent, isn't among the S&P 500's top 10 holdings based on market cap, while Apple (AAPL), ranked second in the S&P 500 by market cap, isn't among the Revenue Weighted Large Cap index's top 10.

The RevenueShares indexes are made up of exactly the same stocks as their nearest benchmarks but in different concentrations, based on how low a stock's price-to-sales ratio is. The large-cap ETF owns Google (GOOG) but would hold considerably less of it than the benchmark index because of Google's lofty price-to-sales multiple.

RevenueShares President Sean O'Hara cites statistics going back 30 years that show that in the 13 years when the price-to-sales ratio for the S&P 500 was above 1, the average return for the market was 7 percent, while in the 17 years when the ratio was below 1, the average return was 16.7 percent. Higher stock multiples signal that investors should lower their return expectations, he says.

For the year ended June 30, 2010, the RevenueShares Large Cap Index beat the S&P 500 by 4.47 percent and the Small Cap Index beat the S&P SmallCap 600 index by 4.18 percent; the RevenueShares Mid Cap Index underperformed the S&P MidCap 400 index by 1.0 percent. "I'm buying these shares at about half the valuation on a price-to-sales basis," says O'Hara. If your market view is negative but you think you can't afford not to be invested, "the thing to do is to figure out how to buy things at lower prices. That's what rebalancing by revenue weight does for you."

Dividend Weighting

Market and economic uncertainty are the reasons that ETF sponsor WisdomTree opted to focus on rebalancing its ETFs according to dividend weighting. "There's nothing people like more than getting dividend payments," says Jeremy Schwartz, director of research at WisdomTree, whose rebalancing process is designed to lower the valuation multiple on the basket of stocks the ETF holds. By selling stocks whose prices have risen relative to their dividend streams, an ETF tends to raise its overall dividend yield, shifting the weight from the lowest- to higher-yielding stocks, says Schwartz.

O'Hara at RevenueShares argues that weighting an index by revenue constitutes a less active bet on the market than an ETF that weights according to dividends, since so many of the stocks in U.S. indexes don't pay dividends. Similarly, weighting by earnings would have knocked out most of the big financial firms such as Citigroup (C) in late 2008 and the first half of 2009, when they had massive asset writedowns but were still viewed as bargains. But globally, a much higher percentage of stocks pay a dividend, so weighting by dividend isn't nearly as exclusive, says Schwartz.

Windward, which is currently 100 percent invested in ETFs, has looked into dividend- and price-to-book-value-weighted ETFs but decided the performance data weren't compelling enough to justify moving away from market-cap-weighted funds. "We're not convinced you're saving enough on valuation [for it to be worthwhile]," says Elan. "ETFs using something other than a cap-weighted index are a little more expensive and would have that hurdle to get over" in order to generate higher returns.

Windward relies on asset-allocation shifts to provide clients with downside protection. Its most conservative portfolio has only a 15 percent weight in equities now, while the most aggressive strategy has a 40 percent exposure to stocks. Since April, when volatility spiked, Windward has increased its exposure to gold ETFs and continues to be heavily invested in bonds through Barclays iShares ETFs holding one- to three-year (SHY) and seven- to 10-year U.S. Treasury notes (IEF), Treasury Inflation-Protected Securities (TIP), and the Barclays Aggregate Bond index (AGG), which includes corporate bonds and mortgage-backed securities.

Actively Managed ETFs

While the vast majority of ETFs are tethered to a benchmark index, actively managed ETFs are gaining more prominence. The U.S. Securities & Exchange Commission defines actively managed ETFs as ones that don't seek to track the return of a particular index. So far, there are just a handful of actively managed ETFs available. AdvisorShares, which specializes in these upstart ETFs, is launching two new ones this month.

Like their passive cousins, actively managed ETFs offer transparency, tax advantages, and lower fees—all features that retail investors are increasingly demanding. And from the perspective of fund sponsors, the main draw is wider distribution to investors than a fund manager could get with a mutual fund.

Noah Hamman, AdvisorShares' chief executive officer, likens the ETF structure to iTunes, which lets an unknown local band post a song, attract a following, and compete directly with Madonna or any other mainstream pop icon. "There are no barriers. You're truly competing with [larger fund firms] on a quality basis," he says. It's a way to avoid being dependent as a mutual fund on a brokerage platform such as Charles Schwab (SCHW) or Fidelity for distribution to retail investors, he adds.

The strategy behind AdvisorShares' Dent Tactical ETF (DENT) was designed "specifically for this economic season," says Rodney Johnson, co-manager of the fund, which invests in a wide range of ETFs. Johnson says he and his co-manager Harry Dent Jr. had long been forecasting a prolonged period of economic contraction to start in 2008.

Switching Asset Classes

In a market that's expanding, getting in and out of positions is counterproductive, while in a contracting market there's more risk than return opportunity in a buy-and-hold approach "because you get these sudden drops where you're just holding on and watching it drop away," Johnson says. His fund has the latitude to invest in international stocks, sectors such as technology, or commodities, all through ETFs designed to hold those asset classes. On Friday, June 25, with the ETF invested 80 percent in equities, his model signaled it was time to get out and the following Monday he switched to 70 percent cash, narrowly avoiding a quarter-ending slump in equity markets around the world.

There's still a lot of resistance among ETF fans to a more actively managed product. Investors seeking active managers who they believe can beat an underlying benchmark should stick to mutual funds, says Windward's Elan. It's not to an ETF manager's advantage to reveal to other market participants where he's over- and underweight an index on a daily basis, or what his trading strategy is, as actively managed ETFs are required to do, because he runs the risk of being front-run or copied by other investors, says Elan. That only dilutes any edge a manager hopes to gain over the market, he adds.

But as long as the market offers elevated volatility and more uncertainty, the option of easy exits and entries, lower taxes on gains, and lower management fees is likely to be of increasing interest to the average retail investor, who may be growing increasingly wary of the stock market's gyrations.

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