The Good, the Bad, and the Ugly

A version of this article was published in the January 2014 issue of Morningstar ETFInvestor. Download a complimentary copy here.

As an observer of the exchange-traded fund business, I see a lot of folly. While I find the genre of "best" or "worst" list articles to be regrettable, I'm writing one because I hope to prod readers, both individual investor and industry insider alike, in the right direction.

In coming up with my list of best and worst ETFs, I asked a simple question: Would I put my own hard-earned cash into the fund--if not today, at least possibly some time down the road?

The answer for the vast majority of ETFs, new or old, is no. I'm interested only in the best funds. Most funds fail this strict test because they're 1) too expensive, 2) run by a fund company I don't trust, or 3) just plain nonsensical.

The Good
The runaway winners in 2013 are iShares' factor funds. IShares got the Arizona State Retirement System to seed them with $100 million each, which is why they're dirt-cheap.

Factor funds are quantitative trading strategies that exploit asset characteristics that have in the past produced excess returns. When critics of active management cite the failure of managers to beat the market, what they really mean is that few active managers have added value above what can be explained by their exposure to factors. There are a surprising number of managers who have beaten the S&P 500 or broad market aggregates--far in excess of what can be attributable to chance. It's when managers are deducted credit for their exposure to factor strategies that few end up beating the market.

So far, researchers have identified four big factors that have worked almost everywhere over many decades: value, momentum, low volatility, and quality. (Size doesn't really count.) With the latest launch, iShares now has at least one ETF for each factor.

  - source: Morningstar Analysts 

Value is the tendency for assets cheap on some measure of fundamental value to outperform assets expensive by such measures. It is the queen of the factors. IShares MSCI USA Value Factor (VLUE), unfortunately, does not add anything new to the market in either cost or methodological advance. VLUE is also shamefully derivative of Rob Arnott's fundamental index.

Momentum is the tendency for assets with strong performance to outperform assets with weak performance. IShares MCSI USA Momentum Factor (MTUM) is the finest momentum ETF right now, and it is a clear step above the costly and opaque  PowerShares DWA Momentum Portfolio (PDP).

Low volatility is the tendency for assets with low past volatility to provide better risk-adjusted returns than assets with high past volatility. IShares covered this factor with the launch of its minimum-volatility ETFs two years ago.

Quality is the tendency for stocks with high profitability, low leverage, and stable earnings to outperform stocks with low profitability, high leverage, and volatile earnings. IShares MCSI USA Quality Factor (QUAL) is one of the cheapest and purest quality factor funds out there. It's a strong competitor to  Vanguard Dividend Appreciation Index ETF (VIG).

IShares also launched two actively managed multifactor funds, iShares Enhanced US Large-Cap and iShares Enhanced US Small-Cap , which charge exceptionally low expense ratios of 0.18% and 0.35%, respectively. Both funds target value and quality factors and will likely be able to offer deeper factor exposures than a portfolio of single-factor funds.

The only thing iShares has to do to win 2014 is to launch low-cost foreign versions of its factor funds.

Honorable Mentions

  - source: Morningstar Analysts 

Schwab's Russell RAFI funds deserve praise. The funds track Russell indexes that weight stocks by leverage-adjusted sales, operating cash flow, and net buybacks plus dividends. They're cheaper than PowerShares' FTSE RAFI funds and, I think, marginally better. Unlike the FTSE RAFI, which rebalances once a year, the Russell RAFI spreads out its rebalancing over four quarters, reducing market impact.

  - source: Morningstar Analysts 

Mebane Faber's Cambria Shareholder Yield funds are a lot more sensible than traditional dividend-sorting strategies. The Cambria funds select stocks of firms with the highest shareholder yields, defined as the sum of dividends, net share buybacks, and debt repayments, divided by price.

  - source: Morningstar Analysts 

Vanguard's international-bond funds are by far the cheapest of their kind. While I'm not enthusiastic about currency-hedged foreign government bonds, Vanguard deserves credit for providing low-cost exposure to an asset class largely untapped by U.S. investors. It's just a shame about the timing. I could see a role for these funds way down the line, when yields are high enough to adequately compensate investors for the risks they bear lending to foreign governments.

The Bad
I could spend all day picking on bad funds. However, a few deserve special scorn for looking like the spawn of marketing departments.

Robo-Stox Global Robotics and Automation ETF (ROBO) is targeted at excitable investors. It holds lots of sexy, potentially revolutionary companies with strong recent performance. While I'm confident disruptive technologies will enhance our standard of living, history shows the fruits of rapid technological advances don't accrue to the owners of capital but rather to society (a big thank you to investors who provide the capital to make this possible).

I'm not sure what LocalShares was thinking when it used actual money to launch LocalShares Nashville Area ETF . The people who started this fund either convinced some investors to part with their hard-earned money or may have even put their own money into starting a firm dedicated to city-based ETFs. The mind boggles. Who are these people? How do they have money?

A few years ago, Oklahoma ETF OOK and Texas ETF TXF shockingly shut down after receiving no interest. My boldest prediction yet: The same fate awaits NASH.

The Ugly

  - source: Morningstar Analysts 

UBS can be relied on to issue risky, complicated, expensive exchange-traded notes. In 2011, the firm issued a series of VIX notes. Rather than offering lower fees to challenge the incumbents, UBS charged 5.35% annual fees, hiding most of it as a weekly 0.077% "Event Risk Hedge Cost."

Unsurprisingly, the two latest ETNs in the UBS income ETN suite are terrible. Both funds take highly risky assets, then slap on 2 times leverage. Hedge funds aren't looking for 2 times leveraged "monthly pay" income strategies. I have a suspicion that UBS' target audience is relatively unsophisticated.

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