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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.

The Russell Low Volatility indexes hold the low-volatility members-as measured by a stock's variability in total returns based on its behavior over the past 60 days-of their base index (Russell 1000 or Russell 2000) at their market-cap weightings. The indexes reconstitute monthly. We recommend waiting to see how the Russell ETFs perform versus their underlying index, given the monthly reconstitution (which could result in a high turnover) and the relatively high expense ratios (LVOL at 0.49% and SLVY at 0.69%). High turnover, which increases trading expenses, and a high expense ratio could eat into the returns of the fund. 

The PowerShares ETF follows a much simpler index, which takes the 100 stocks out of the S&P 500 with the lowest volatility over the past 12 months and weighs them by volatility (stocks with the lowest volatility receive the highest weightings). The fund is reconstituted quarterly and carries a lower expense ratio of 0.25%.

High momentum (as measured by a stock's return over a specific time period) is another strategy that has shown to outperform across almost all markets and asset classes. The strategy is now available in an ETF structure: Russell 1000 High Momentum HMTM and Russell 2000 High Momentum SHMO.

These ETFs track indexes that follow the same construction methodology as the Russell Low Volatility indexes, except that they hold stocks with the highest momentum, as measured by a stock's cumulative return over the past 250 trading days, excluding the past 20 trading days. Again, we recommend watching these ETFs before jumping in to see how they perform versus their indexes. HMTM's and SHMO's expense ratios are 0.49% and 0.69%, respectively.

Different Flavors of Value and Growth
Russell also launched a family of investment discipline ETFs that seeks to provide exposure to different flavors of value (low P/E, dividend income, contrarian) and growth investing (aggressive growth, consistent growth, and growth at a reasonable price). Each of these ETFs track indexes that apply specific screens to the Russell 1000 Index.

While there are other funds that appear to be fairly similar to many of the Russell funds, one stands out among growth-oriented ETFs: Russell Growth at a Reasonable Price GRPC. It layers on a valuation screen over a growth screen, which results in a portfolio that is heavier in industrial firms and lighter in technology firms, relative to other growth funds. The fund's trailing 12-month P/E ratio is more in line with the overall market's. The ETF's expense ratio is 0.37%.

German Appeal
ETFs that invest outside the United States have been a popular category of new launches this year, and one we find appealing is Market Vectors Germany Small-Cap ETF GERJ.

Germany tends to be underrepresented in most portfolios given its lower marketcap- to-GDP ratio, relative to other large, developed economies. And when compared with the broad market iShares MSCI Germany Index EWG, small-cap German stocks are less correlated to the S&P 500 (91% for EWG versus 85% for MSCI Germany Small Cap Index). EWG is dominated by large-cap firms that compete directly with many of the large-cap multinational U.S. firms that populate the S&P 500.

GERJ's largest sector weightings are industrial and technology (35% and 16% of assets, respectively). These firms in these sectors tend to be highly specialized with defendable competitive advantages. GERJ's expense ratio is 0.55%.

Patricia Oey is an ETF analyst with Morningstar.

Patricia Oey is an ETF analyst at Morningstar.

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