Three ETFs We Would Like to See

The ETF universe has exploded over the past three years as issuers and investors alike embraced the newfound ability to slice and dice the global capital markets. Today, individual investors looking to diversify their portfolio can look far beyond the old question of bonds versus stocks. Exotic asset classes such as commodities, global real estate, emerging-markets equities, and international small-cap stocks are all available at a low cost. Equity funds divided by country, sector, and subindustry allow individuals to make diversified macroeconomic bets without needing to invest in dozens of stocks. And the innovation continues today, for better or for worse, with new ETFs being registered each week. Recently, many new funds hope to hitch a ride on the global infrastructure and trade boom or track currency movements. Even newer funds have started to move into areas that were once the exclusive domain of hedge funds and sophisticated endowments. But even amid this wide diversity of potential investments, we still see a few gaps that we hope ETF issuers will step up and address soon.

Long-Short ETFs
Of the more than 800 ETFs in our database, only three offer an automated long-short equities strategy. All three replicate holding an index portfolio while writing covered call options to produce more income. We would like to see more long-short ETFs with clear automated methodologies rooted in academic research, as they would provide valuable access to returns previously captured only by institutional investors. For example, researchers have found that stocks with a large short interest relative to their market capitalization underperform those with a very small short interest. Because NASDAQ surveys and publishes the short interest of every U.S. equity on a timely basis, one could create an equal-weighted index that buys the 100 stocks in the S&P 500 with the lowest short interest as a percent of total float while shorting the 100 stocks with the highest short interest as a percent of total float. Restrictions on the domain of potential stocks (such as limiting it to only stocks in the S&P 500) would be necessary to ensure liquid holdings, but such a portfolio would provide an excellent source of returns with a low correlation to other asset classes.

Momentum ETFs
Finance researchers have identified and agree upon four major risk factors that provide returns within equity markets: market risk, size risk, value risk, and momentum risk. The first three are the best known, formally classified by Eugene Fama and Kenneth French in a seminal 1993 paper, and they are the reason that ETFs today slice the equity universe into size portfolios from mega-caps to micro-caps and style portfolios from deep value to aggressive growth. However, no ETF has sliced up the market index to produce momentum portfolios, which capture the future excess return of stocks that had high returns over the trailing year. Mark Carhart in 1997 found that those stocks produced higher-than-average returns over the following year, and that these higher returns had little correlation with the other known sources of returns. A portfolio tracking the high-momentum stocks in a national market would be easy to construct, and an index could keep the turnover low and steady by only changing one twelfth of the portfolio each month, holding each month's high-momentum stocks for a year at a time.

Volatility ETFs
Equities not only provide a return, but they also have a volatility that estimates how risky they look in the near future. By looking at the prices of options on equities or indexes, it is possible to separate the expectations of volatility for a given investment from its current price. The most famous example of this is the VIX index, which Chicago Board Options Exchange calculates from the expected volatilities priced into market-traded options on the S&P 500 index. While it has historically hovered around 20, the VIX falls during quiet market periods and spikes when a flurry of trading activity buffets the stock market. An investment in this index would provide a valuable hedge against periods of heightened uncertainty, and since volatility has traditionally been higher in bear markets, it would also somewhat hedge losses in equities. Individual investors currently have a hard time speculating on the VIX, as futures in the index require minimum investments well over $10,000, but an ETF could open this valuable diversifier to the masses.

ETFs That YOU Would Like to See
Now that you know what's on our radar, what new ETFs would you like to see? Post your thoughts in this Morningstar Discuss thread.

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