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ETF Specialist

How to Assess Strategy ETFs

Be skeptical and scientific when looking at newfangled funds.

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The exchange-traded funds rolling out these days aren't the quintessential index funds of yesteryear but are often active strategies themselves. Many are seductive--who doesn't want more yield or lower volatility? You might have plumped money in one yourself. Or you may have held off buying a newer strategy ETF, and for good reason. They're a bit trickier to understand, charge a lot more, have limited histories, and often have that whiff of faddishness. Experienced hand or not, you'd probably feel more comfortable with a framework for understanding more-complex funds. As a starting point, think of picking a strategy as very much like being an active manager. Indeed, many hedge funds earn their keep by simply rotating among and blending well-known strategies. The market is hard to beat (isn't that why we like ETFs?), so expect assessing strategies to be hard work.

Fundamentals
The first question to be asked of any strategy ETF: How does it make money? If you're buying a strategy in the hopes of earning market-beating returns, you better have a very good reason to justify your belief. The ETF providers sure don't. If they did, they'd quit the ETF industry, open up hedge funds, leverage their ideas to the hilt, and mint money. In other words, their comparative advantage is in selling products, not developing cutting-edge investing ideas. So what if the ETF came out with shiny brochures and eye-popping back-tested returns? The very existence of a supposedly market-beating strategy in an ETF should make you wary: The strategy is often 1) repackaged risk; 2) not very well supported with theory or data; or 3) overcrowded. You want a good, intuitive story as to why a strategy will continue to create excess profits, despite everyone knowing about it.

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

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