Myriad strategy ETFs have come to market, but investors' allocations to these vehicles should depend on comfort level, says ETFInvestor editor Sam Lee.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. In the last year, we've seen the launch of many new strategy exchange-traded funds, but are any of them right for your portfolio? I'm here with Sam Lee--a strategist and also the editor of Morningstar ETFInvestor--to take a look.
Sam, thanks for joining me today.
Sam Lee: Thanks for having me here.
Glaser: Let's start with the definition of a strategy ETF. What are these, and how do they differ from traditional funds?
Lee: Traditional ETFs are mostly index funds. So they try to offer passive broad exposure to a market or market segment. Strategy ETFs on the other hand tend to offer an alternative exposure that tries to beat the market or offer some kind of enhanced exposure. You can think of dividend-weighted ETFs as strategy ETFs. These ETFs are what you could call quasi-actively managed because they do represent active tilts against the market.
Glaser: There were a lot of launches, probably some better than others. What are some of your favorites that you've seen come to market recently?
Lee: I'd say that in the past year, iShares has probably launched the best series of strategy ETFs. They call them the Factor ETFs. So the iShares MSCI USA Factor ETFs, and then they have various tickers.
And the reason why they're so excellent is because, number one, they're cheap. Most of them charge around 15 basis points, or 0.15%, of assets annually. And that's very close to what you would get from a passive exposure. And number two, they're backed by sound academic research. You have four of these ETFs; one that covers momentum, one that covers quality, another that covers size, and the other that covers value.
I'm not too interested in the size and value ETFs because if you've looked at the ETF market in general, you'll see that there are tons of value indexes, dividend indexes, small-cap, mid-cap indexes, and those are all essentially value and size factor strategy ETFs. So iShares isn't really offering anything new with those two ETFs, but the quality and the momentum ETFs I think are very excellent and very interesting.
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Glaser: For that quality fund, that could be something that's somewhat hard to quantify. How does iShares select and really screen on quality there?
Lee: IShares or more specifically MSCI, the people who invented index, have finally found Warren Buffett and they basically look for companies that Buffett would consider a high-quality. So that is companies with high profit margins, low earnings variability, and very low debt. And basically every single stock in the U.S. market is scored on these metrics, and the ones that have the highest composite score are weighted more heavily or make the cut into this ETF.
Glaser: For many value investors, momentum can seem like a bit of a dirty word. Why do you like this momentum ETF? What attracts you to it?
Lee: Number one, I completely agree that momentum is a dirty word. Momentum-chasing has hurt plenty of investors, but interestingly enough academic research is shown that momentum persists especially over the next one to 12 months, and then after that high-momentum stocks tend to underperform. So, if you take a disciplined approach to exploit the momentum; that is the stocks that have done the best over the past 12 months, there's the strong evidence that it would've earned you excess returns.
Now one problem is it's expensive because you're turning over your portfolio a lot; and number two, it's very tax-inefficient because you're harvesting lot of short-term capital gains. You're not letting your capital gains compound on each other.
The ETF I think is very clever in that it avoids both of those. Because number one, the ETF is very cheap and the underlying liquidity of the stocks that the ETF invests in is very high; and number two, ETFs can actually churn their internal portfolios without actually distributing much in the way of capital gains. So I think this momentum strategy is a very, very good thing to implement in the ETF format.
And the way iShares, or more specifically MSCI, defines momentum is they look at returns over the past six months and returns over the past 12 months and then they divide those returns by three-year standard deviation. And they find the risk-adjusted returns of those, and then they create a score for the six-month and the 12-month momentum. And they average that, and the stocks that have the highest momentum scores are the ones that are overweighted or put into this ETF, and the stocks with the lowest ones are either underweighted or completely kicked out. And this is repeated every six months.
It seems like a dumb strategy; that is you're chasing returns up and you're kicking out losers, things that have gotten much cheaper. But historically this has been a very powerful strategy that has worked in virtually every market that's been examined.
Glaser: Are there any other strategy ETFs that you find compelling right now?
Lee: I think two other ETFs that were launched with these iShares factor ETFs – iShares calls them the Enhanced equity ETFs, so iShares Enhanced U.S. Large-Cap and iShares Enhanced U.S. Small-Cap and these ETFs, I would consider multifactor ETFs. So they're technically actively managed, but they're managed using quantitative models that try to combine both quality and value together.
Normally if you want to combine quality and value, you will have to own a quality ETF or quality fund and a value fund and you put them together. The problem is that dilutes the tilts of each fund because each fund only represents half of what they would have normally taken up. This avoids that by looking for stocks that exhibit strong characteristics of both quality and value and overweighting those, and I think it's a very interesting idea because iShares has actually come out and put these with very, very low fees.
For example, Large-Cap Enhanced ETF charges 18 basis points, the Small-Cap Enhanced ETF charges 36 basis points. So you're getting close to passive management fees for what is I think a sound factor-based strategy.
Glaser: Looking across the strategy ETFs then, how should investors think about using them in a portfolio? Is it a substitute for a core holding? Is it more of a satellite holding? How should you actually use these in practice?
Lee: I think it depends on how strongly you believe in these factor-tilt ETFs, or strategy ETFs, because if you are comfortable owning actively managed mutual funds in your portfolio as your core holdings, as many investors do, then there's nothing that would prevent you from owning these factor or strategy ETFs as your core holdings. The way I think about it is many of these ETFs are dirt-cheap or the best ones are dirt-cheap. So, even if they don't work out, so that is the supposed advantage isn't realized going forward, you haven't lost anything, if at all because these, especially iShares ETFs, charge close to passive management fees.
So it depends on how strongly you believe in them. Personally, I'm comfortable with putting most of my holdings in these types of factor ETFs, but someone who is less sure or less confident in whether these strategies will work in the future, should probably relegate them to a tactical tilt.
Glaser: Sam thanks for your thoughts on the strategy ETFs today.
Lee: Thanks for having me here.
Glaser: For Morningstar, I'm Jeremy Glaser.
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