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Circle These Picks Amid the Crop

Investors now have access to low-volatility and high-momentum strategies.  

Patricia Oey, 08/16/2011

This article first appeared in the August/September 2011 issue of Morningstar Advisor magazine. Get your free subscription here.

The torrid pace of new exchange-traded fund launches has continued in 2011. The past six months have seen more than 200 new ETF products, bringing the total number of funds to nearly 1,300. Fund companies have been pushing out dividend funds, high-yield funds, and international funds in an effort to address investors' demand for income and growth. Here are the new launches that we like. But first, some words of caution.

Buying a New ETF
Investors should exercise extra caution when investing in new ETFs, especially when considering niche products. A key risk is that the ETF may not behave as expected. Consider investors who rushed into United States Oil USO and found themselves falling far behind oil's spot-price performance. Financial innovation is often messy; no doubt many investors in new ETFs wished that they didn't volunteer to be beta testers.

Investors can usually avoid nasty surprises by sticking to ETFs that invest in comprehensible, traditional asset classes, such as liquid, investment-grade stocks and bonds, and by avoiding bells and whistles, such as leverage and inverse performance. Another risk is that the ETF may not gain traction, leaving investors to pay unexpected capital gains or even the ETF's shutdown costs. Finally, exotic vehicles sometimes come with exotic tax implications. Unless investors want to deal with the risk of a whole new set of tax schedules to file, they might want to hold off until they get a sense of the ETF's tax treatment.

There's also that pesky issue of liquidity. It often makes sense to let an ETF season and gain assets and liquidity. Doing so is a useful way to get a vote of confidence from the market that the ETF probably doesn't have superior competitors that investors may have overlooked or implementation issues. If the underlying securities of an ETF are liquid (such as U.S. equities and large-cap developed-markets equities), expect the ETF to trade at small premiums and discounts and with tight spreads, even if the ETF itself is not that liquid. For products that hold less-liquid underlying holdings or international equities, it is more important to monitor the bid-ask spread, which shows how much the market "agrees" on the price of the ETF. Some ETFs can consistently trade at premiums, often indicating a less-liquid asset class. Always use limit orders when buying new ETFs.

Buying a new ETF doesn't have to be a nerve-wracking experience. A few simple precautions, such as having a clear picture of its expected behavior and tax implications and using limit orders, can make buying a new ETF a less-costly experience. PAGEBREAK  

Low Volatility, High Momentum
While many of the newly launched funds are not suitable for most investors, there are a handful of ETFs we find interesting. Low volatility and high momentum are two strategies that have a track record of generating appealing risk-adjusted returns.

There were no ETFs that specifically followed a low-volatility strategy until May, when three were launched: PowerShares S&P 500 Low Volatility SPLV, Russell 1000 Low Volatility LVOL, and Russell 2000 Low Volatility SLVY. There are some differences between the Russell ETFs and the PowerShares ETF.

Patricia Oey is an ETF analyst at Morningstar.
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