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ETF Specialist

Innovative ETFs

Change is apace in the ETF industry. Here are some of the better ideas to have come out.

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Exchange-traded funds are no longer just index-trackers for Ma and Pa. The industry is undergoing its own Cambrian explosion, where every investing idea under the sun is being tried in the exchange-traded format, from hedge fund wanna-bes to quadruple-leveraged S&P 500-gold spread trading vehicles. Many won't survive, but the ones that have been thriving include kinds never seen before. We've assembled a list of newer ETFs that represent advances in the state of the art: Each fulfills a need that has never been truly satisfied before by ETFs or perhaps even by publicly investable vehicles. A word of caution: As fairly new funds, they have modest trading volume and should be bought and sold with limit orders.

 PIMCO Enhanced Short Maturity Strategy ETF (MINT)
Inception: 11/16/2009
AUM: $1.3 billion
Avg. 3-Month Volume: 157,028
Expense Ratio: 0.35%
Yield: 0.89%

PIMCO's actively managed MINT is meant to be a cash complement. Rule changes have made money markets more alike, pushing down yields in short, high-quality debts. There's potentially a lot of value just beyond the artificially delimited quality and maturity levels, and MINT's broad mandate exploits the gap. However, don't be lulled into thinking the fund is good as cash. MINT doesn't guarantee a fixed price level. In fact, most investors are better off in high-yield savings accounts, which are FDIC-insured and possibly higher yielding than MINT's below 1% yield. But if you've tapped out all the safe high-yield options and deal with big sums (think $100,000-plus), MINT may be an attractive complement to your cash allocation.

 Cambria Global Tactical ETF (GTAA)
Inception: 10/25/2010
AUM: $184.4 million
Avg. 3-Month Volume: 122,346
Expense Ratio: 0.99%

Mebane Faber of the Ivy League Portfolio fame manages one of the most successful active ETFs, though at $184 million the fund is a minnow. GTAA uses momentum measures like moving averages to time entry and exit into a wide variety of asset classes. Price-based momentum is often derided as witchcraft. But the strategy's profitability has been so puzzlingly pervasive across asset classes and through time that it's considered a serious anomaly. The Economist goes as far as to call it a "juggernaut through the efficient-markets hypothesis." The ETF fulfills a useful niche by offering a possibly lower-cost option for trend-following investors. Most individuals cannot cheaply turn over their portfolios due to commissions, bid-ask spreads and (god forbid) capital gains taxes. The ETF structure mitigates much of those costs by its in-kind creation and redemption process and institutional outsourcing of rebalancing trades. If you're a believer in momentum, this fund might be a good fit for you.

 United States Commodity Index (USCI)
Inception: 8/10/2010
AUM: $487.3 million
Avg. 3-Month Volume: 54,402
Expense Ratio: 1.24%

USCI is a commodity fund based on the work of Yale professor K. Geert Rouwenhorst and colleagues. It attempts to exploit momentum and backwardation as signals of inventory tightness, which, according to the theory of storage, predicts excess returns. While academics have created their fair share of products that don't work, the industry's record as a whole is a lot worse. We think the fund's rigorous theoretical basis helps its chances of outperforming over products of more dubious provenance, but it's no guarantee.

Credit Suisse Merger Arbitrage Liquid Index (CSMA)
Inception: 10/1/2010
AUM: $104.9 million
Avg. 3-Month Volume: 33,365
Expense Ratio: 0.55%

Merger arbitrage is a relatively simple strategy that aims to capture the spread that often exists between the proposed offering price and the market price of a merger target's public stock. Merger arbitrage profits are the reward for acting as an insurer to the target's stockholders, who may wish to lock in their gains. It's what's called an alternative beta, and may offer diversification benefits to a traditional portfolio of stocks and bonds. Until very recently, the main way to gain access to the strategy was through hedge funds, which often use leverage to justify their high fees. The strategy isn't for everyone, but out of the wave of new ETFs, it's one of the few that's backed up by rigorous research and a sensible implementation.

Low-Volatility ETFs
Strangely enough, low-volatility stock portfolios have performed about as well as the market, but with less risk. The finding isn't just isolated to U.S. markets, but extends globally. It may be that extremely risk-tolerant, leverage-constrained investors load up on the riskiest assets, driving up their value. Other explanations include irrational lottery-seeking investors who overpay for stocks that have the potential to pay out big. The anomaly is one of the bigger puzzles in finance and deserving of its own investable strategies, much like value investing. Russell and PowerShares have recently launched low-volatility strategy ETFs: PowerShares S&P 500 Low Volatility  (SPLV) and Russell 1000 Low Volatility ETF  (LVOL). Both ETFs have only about $30 million in assets and require a bit more care than usual to trade.

Factor-Based Investing
A recurring theme in our favorite innovations is the democratization of sensible institutional strategies in cheaper, liquid wrappers. Some strategies that were locked up in the ivory tower or in quant hedge funds deserve greater exposure. We hope that with the greater availability of these tools, investors and advisors will begin to think of investing not just as an exercise in allocating assets, but in risk factors. By controlling factor exposures via transparent vehicles, investors can better understand and accept the risks they're taking on.

Samuel Lee does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.