3 Off-the-Beaten-Path ETFs

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Some investors may wish to use total market index funds to populate their portfolios and call it a day, but other investors may wish to venture off the beaten path a little bit. Joining me to discuss three smaller exchange-traded funds is Alex Bryan. He is Morningstar's director of passive strategies research for North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, in the most recent issue of ETFInvestor, you looked at some off-the-radar exchange-traded funds, and we are going to talk about some of the ones that you think are worthy of a further review on the part of investors. Let's start with iShares Edge Investment Grade Enhanced Bond ETF. The ticker is IGEB. So, this is one that someone might use to fill sort of that core intermediate-term bond slot in their portfolios?

Bryan: So, this is actually a corporate-bond-focused ETF. So I think this is a good component of a bond allocation, but it probably shouldn't be the entire bond allocation in your portfolio. This is effectively a quality and value strategy. It essentially starts with a broad universe of investment-grade-rated corporate debt, and then it screens out bonds that have higher probabilities of default, which might be overpriced by investors reaching for yield. And then, of the bonds that are remaining, it tilts toward those that are offering attractive yields relative to their default risk. So, that's the value component of the strategy.

So, this is a good way of basically removing the riskiest investment-grade corporate bonds without sacrificing much return. I would expect something like this to actually offer better returns than the broad investment-grade corporate market over the long term, and it's very competitively priced at 18 basis points.

Benz: Your next off-the-beaten-track ETF is IQ S&P High Yield Low Volatility Bond. The ticker is HYLV. Alex, first, let's quickly talk about why your team has historically been a little bit reticent to recommend high-yield bond ETFs and also how you think this fund maybe approaches that space in a more sane, risk-conscious way.

Bryan: Well, as you alluded to, high-yield bonds are a risky corner of the market, and this is an area where active management of both credit and liquidity risk can make a lot of sense. A lot of funds out there--they are just following the composition of the market and oftentimes that means owning a lot of the most heavily indebted companies out there. What I really like about this fund is that it's investing in high-yield bonds in a risk-controlled way. It's effectively looking for bonds that have low yields and that are less sensitive to changes in credit spreads than some of their peers. So, this is going to tilt toward higher-quality junk bonds. Most of the portfolio is parked in BB bonds. And I think that's important if you are looking for a more defensive way of getting exposure to this area of the market.

Benz: Your last idea for an off-the-beaten-path ETF is Vanguard US Multifactor. The ticker is VFMT. This is, obviously, an equity--or maybe not obviously--it's an equity exchange-traded fund that employs a multifactor strategy. First, let's talk about what multifactor means and then get into this specific fund.

Bryan: So, multifactor strategies are effectively looking for stocks that have an attractive combination of different characteristics like low valuations, strong recent price performance or momentum, strong quality, things like that. Each of those characteristics has historically been associated with market-beating performance. But each of these characteristics, or factors as they are called in the academic world, goes through long stretches of outperformance and underperformance. So, if you are going to just be a value investor, there's going to be periods where that works, there's going to be periods where that doesn't work.

The basic premise behind owning a multifactor fund is that by combining these different style tilts into a single portfolio, you can better diversify your risk, which can reduce the risk of underperforming for an extended period of time. Now, it doesn't completely eliminate it. You are still taking active bets here. And these will not always outperform. But it's effectively better diversifying your individual style bets.

Benz: And it's a Vanguard fund, so it's pretty inexpensive, I'm guessing, right?

Bryan: So, there's lots of multifactor funds in the market, but I think what makes this one unique--there's a couple of things. One, this particular strategy is investing across the entire market-cap spectrum. So, it's investing in large-cap, mid-cap, and small-cap stocks. And then, secondly, it is active in its implementation, meaning it doesn't track a benchmark. So, that gives the managers some flexibility about when they want to rebalance the portfolio. So, they may not make a trade if the costs of doing so exceed the potential benefits or the expected benefits of doing so. So, there's some implementation advantages from the strategy. And true to Vanguard's nature, it is a very low-cost strategy. It charges 18 basis points. And I think this is a really good core holding even though it sits in the Morningstar mid-cap blend category; because it's offering full market-cap coverage, I think this could be a good replacement for even a large-cap index fund.

Benz: But obviously, not tilting as much toward the large and giant caps as the total market index would?

Bryan: That's right. Yes. So, it's sitting within the Morningstar mid-blend category. While it does own large-cap stocks, it certainly has much less of a tilt toward those names than something like the S&P 500 would. But I think the fact that this owns stocks across the entire market-cap spectrum is beneficial for two reasons. One, it improves diversification. And then, secondly, I think, it's really important to note that factor investing has historically worked better among smaller-cap stocks, and the fact that this invests in small-cap and mid-cap stocks I think will actually improve the efficacy of the strategy and potentially help its performance a little bit over the long term.

Benz: So, these ETFs are all not huge, and there can be some liquidity considerations, especially for smaller ETFs that don't trade a lot. Let's talk about what investors should know before they venture into these or any of the off-the-beaten-path ETFs.

Bryan: So, smaller ETFs do tend to be a little bit more thinly traded. So, it's really important to use limit orders to make sure that you get the price that you think you're going to get. Because if you use a market order, there's a risk that the price that you see could be different than the price that you actually get. Limit orders are always a best practice, but it's particularly important for more thinly traded funds like these newer ETFs.

Benz: OK, Alex. Thank you for being here to provide the short list of ETFs worthy of further research. Thanks for being here.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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