Computer-Powered ETFs

A version of the following article appeared in Morningstar ETFInvestor, a monthly publication that offers our latest thinking on the ETF market, including two model ETF portfolios.

Actively managed exchange-traded funds--the so-called holy grail of the ETF industry--thus far remain elusive. Several roadblocks have kept them from getting off the ground, including significant regulatory hurdles that may take some time to surmount. While an active ETF may be months or years away, ETF providers are getting as close to active management as they can by constructing indexes that are shaped by quantitative models, which use many of the same criteria that active managers do. And like active managers, these ETFs aim to outperform conventional benchmarks.

A Little Background
Using quantitative models to pick stocks is nothing new. Quantitative strategies have been around for a while, and they've also grown in popularity among conventional fund investors. Many big firms, including Vanguard, Schwab, and American Century, include quantitative funds in their lineups. And a few fund shops, such as Bogle and Bridgeway, specialize exclusively in quantitative strategies. Conventional quantitative funds use computer models to screen and rank stocks based on a variety of investment metrics, including relative valuation, fundamental strength, and technical and momentum factors. ETFs that track enhanced indexes use similar techniques to construct their benchmarks.

PowerShares has the largest lineup of quasi-active ETFs. After the launch of a slate of sector funds last year, the Dynamic lineup now includes 36 funds. (More on the PowerShares Dynamic methodology follows.) Most of the Claymore stable of ETFs is dedicated to quantitative strategies; its lineup includes the likes of Claymore/Sabrient Insider NFO, which monitors insider trading and changes in analysts' earnings estimates to identify promising stocks. First Trust also has a couple of entrants in the quasi-active market, such as First Trust DB Strategic Value FDV, which tracks an index that attempts to identify 40 value-priced large-cap firms that generate returns on cash in excess of their cost of capital. Finally, I include Vanguard Dividend Appreciation ETF VIG in this group because it uses quantitative tools to screen out firms in its benchmark that may have trouble growing dividends.

Pros and Cons
Like any investment process, quantitatively driven strategies have their strengths and weaknesses. On the plus side, the quantitative process enforces investment discipline--the computer models are consistent and repeatable. There also are some advantages to removing the "human element" from investing. Computer models don't get swept up in market mania or investing fads to which human managers might fall prey.

On the negative side, left to its own devices, a model will gradually lose effectiveness because, when a fund's approach is working, others will try to copy what it's doing, thereby eroding its advantage. Consequently, it's imperative for quant teams to continually evaluate and enhance their models. The best active quantitative managers are constantly testing their models and looking for ways to improve their effectiveness. It's not yet clear how much effort ETF providers are devoting to testing and enhancing the models behind these funds.

As another drawback, quant funds have above-average turnover rates, which could impair their tax efficiency. So far, no quasi-active ETF has distributed capital gains, but the oldest of these funds has only been around for three years. The ETF providers I've talked to are confident that the ETF in-kind creation and redemption process should be sufficient to absorb any capital gains, but I'm still cautious. These funds have seen a lot of trading. For example, PowerShares Dynamic Market PWC had turnover of 103% last year, and PowerShares Dynamic Mid Cap Value PWP had turnover of 117%. This isn't necessarily a deal breaker, but it's possible that these ETFs could be less tax-efficient than the typical ETF competition.

The Need for High Standards
Quant firms keep their computer models private because they understandably don't want to reveal their methods to the competition. Accordingly, anyone who analyzes quant funds operates in a vacuum to a certain extent. There's a point at which investing in quant funds comes down to an act of faith. That's why I think you need to have high standards when it comes to other factors like the management's experience, the analytical resources that support the model, the strategy's track record, and expenses.

Some of these funds are disappointing when it comes to expenses. The Claymore and PowerShares offerings all carry expense ratios of 0.6%. That's on the high side for ETFs. I might be willing to pay up for these funds if there was evidence that they could ferret out promising, undervalued stocks. But most of these ETFs have only been around for a few months, which is far too short a period to provide meaningful performance data. That's why I've isolated this analysis to quasi-active ETFs that have the longest track records or those developed by quantitative teams that have public track records elsewhere. That pares the list down to three--PowerShares Dynamic OTC PWO and PowerShares Dynamic Market, both of which have been around for more than three years, and Vanguard Dividend Appreciation ETF, which employs a model developed by the firm's seasoned team of quantitative analysts, who own long-term track records at other funds. I quickly eliminated PowerShares Dynamic OTC because it restricts its view solely to stocks listed on the Nasdaq. That's an arbitrary division in my mind. It's like basing a fund on stocks that start with the letters A and B. Not surprisingly, this ETF has quirky sector weightings that make it an awkward fit for a portfolio. So, it doesn't hold much appeal.PAGEBREAK

PowerShares' Entrant
PowerShares Dynamic ETFs are tethered to AMEX Intellidex indexes. These benchmarks were developed by AMEX with the assistance of PowerShares' John Southard, who honed his quantitative chops at Chicago Investment Analytics, the firm that developed Schwab's successful equity-rating system (which has produced solid results at Schwab Core Equity SWANX). The AMEX Intellidex model uses 25 quantitative factors to identify stocks that are likely to outperform. The factors fall into four broad categories--valuation, growth, risk, and momentum, which is similar to the approach used at other successful quantitative funds. Moreover, the model includes factors that active managers use in their analysis to identify promising stocks. On the whole, I think the methodology is sensible, and it was thoroughly tested and responsibly developed.

PowerShares Dynamic Market's early results are enticing. The fund's three-year trailing returns surpass more than 90% of all large-blend funds. Granted, it has benefited from a marked bias toward smaller fare. However, when compared with large-blend funds with similar size characteristics, this ETF's performance has been competitive.

On the other hand, the rally in small- and mid-cap stocks has stretched valuations, and this ETF's portfolio doesn't look particularly cheap right now. It owns fewer 4- and 5-star stocks than competing offerings.

The higher expense ratios on the Dynamic ETFs also stick in my craw. So, while the methodology behind the PowerShares Dynamic funds holds some appeal, I'm still not ready to recommend them.

My Pick
The one ETF that stands out from the quasi-active crowd is Vanguard Dividend Appreciation ETF. This is a dividend-oriented fund with a twist. Its benchmark is Mergent Dividend Achievers Select Index, a market-cap-weighted index of firms that have increased their dividends in each of the last 10 years. But Vanguard went a step further by developing quantitative screens that are applied to the benchmark to identify those companies that are most likely to continue to grow dividends over time. For example, recently it tossed out names such as Citigroup C, Pfizer PFE, and Chevron CVX because the model indicated that these companies may not be able to increase their payouts as time goes on.

This ETF has a short track record. So why am I willing to get behind it? The answer lies in the experience of the team that developed the screens. Vanguard's quantitative equity group has demonstrated its ability to run and develop successful quantitative strategies. The group runs sleeves in a number of the firm's multimanager mutual funds, and it's in sole control of Vanguard Strategic Equity VSEQX, a mid-blend quantitative mutual fund that owns an impressive track record.

Furthermore, I'm compelled by the dividend-growth strategy. Companies that have the financial wherewithal to grow their dividends for 10 straight years are generally solid franchises so it's not surprising that this fund dedicates almost 70% of its portfolio to wide-moat stocks. Dividend growth is an excellent sign of financial health, and this fund's portfolio has a cumulative return on equity higher than most competing ETFs. These financially sturdy stocks also tend to hold up better than racier stocks in market downturns. What's more, although its portfolio isn't particularly cheap right now, its valuation characteristics look better than the competition: It owns more 4- and 5-star stocks than most other dividend-oriented funds as well as the S&P 500. Finally, this ETF is attractively priced at 0.28%, which should also work in its favor over time.

A low expense ratio, an experienced and proven management team, and sensible strategy. That's a winning combination in my view, and it's my pick for the best of the quasi-active crop.

Disclosure: Morningstar licenses its indexes to certain ETF providers, including Barclays Global Investors (BGI) and First Trust, for use in exchange-traded funds. These ETFs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs that are based on Morningstar indexes.

Sonya Morris an analyst with Morningstar and editor of ETFInvestor.