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Friday, October 04, 2013

What Do All These New ETFs Bring to the Table?

Reported by Casey Quinlan

ETFs are an investing product that are becoming more versatile by the week.

There are hedged ETFs like those offered by Deutsche, those that follow global currencies as well as those that cover gold miners offered by Direxion, and, of course, one that will follow the digital currency known as Bitcoin.

The definition of what constitutes a viable ETF investing strategy is also growing, particularly as firms promoting active formats continue to storm the regulatory ramparts. For example, Eaton Vance has is working to get regulatory approval for a new idea in actively managed ETFs which the firm hopes to franchise.

These moves have already spurred healthy debate at the Morningstar ETF Conference currently in progress in Chicago.

A number of other players have tried to put their stamp on the trend.

One of the featured flavors in these experiments is fundamental ETFs.

When Charles Schwab [profile] introduced its six ETFs tracking the Russell Fundamental Index Series, it created a stir in the financial media, with MarketWatch's Chuck Jaffe and IndexUniverse's Paul Britt covering the ETFs.

The ETFs aim to guard against volatility in stocks and companies heavily weighted in the index.

Britt wrote that the ETFs would broaden the choices for fundamental exposure in an ETF and take a contrarian view. He also added that the fundamental approach should be compared with cap-weighted indexing, not with active management.

Chuck Jaffe called the ETFs "mousetraps" for some investors, because although studies show this type of indexing performs better over the long-term, the stock market is seeing record highs, saying traditional indexing would offer a better fit for the current market.

In an interview with MFWire, Dan Waldron, senior vice president and ETF Strategist for First Trust [profile] , said he wanted to clear the air on the topic of "true fundamentals" vs. new fundamental ETFs that he says only generate better beta as opposed to true alpha. First Trust has the AlphaDEX line of ETFs, which were launched 7 years ago and use value to price, cash flow to price and return on assets as value factors and 12-month price appreciation, sales to price and one-year sales growth. Some of First Trust Large Cap Core AlphaDEX fund's top holdings are Netflix, Sealed Air Corporation and Pioneer Natural Resources. Its year-to-date return is 18.50 percent.

Waldron argues that the factors used for new ETFs, such as total dividends or total earnings, aren't factors he considers fundamental.

"If you're using alternative measures like size, that's not fundamental. It's a better way to index…When people are deciding whether they like a stock they don't talk about things like the value of a company or total earnings, they talk about things like price to earnings ratio," he said.

Waldron said fundamentals have been catching on as of late because fund firms see that advisors have a need for a low-cost, tax-efficient and transparent ETF with the advantage of beating the benchmark.

"Most advisors still believe in active managers and still believe in beating the market and they have the opportunity to do better. We're saying if you're unhappy with your mutual fund fund, beat the benchmark with a tax efficient low-cost ETF," he said.

Research Affiliates released a comment in response to a question on whether the new Schwab ETFs represent true fundamentals. Spokesperson Joel Chernoff stated, "Smart Beta Solutions break the link between price and weight in the portfolio, leading to a more efficient portfolio. Using ratios that include price as either a numerator or denominator restore the link with price and are thus a drag on returns."

Charles Schwab spokesperson Alison Wertheim commented in turn: "The Schwab Fundmental ETFs screen and weight securities based on fundamental factors: adjusted sales, cash flow and dividend + buybacks. Working with pioneer Rob Arnott, Schwab has expanded the array of Smart Beta strategies available in the market. Depending on the factors used, the index construction methodology, and underlying index, there may be a great deal of variability among today's smart beta strategies."

Morningstar's Alex Bryan commented on the various debates over new fundamental ETFs like Schwab's.

"Fundamental is not intended to say its intrinsic value like stock analysts. Fundamental means looking at something other than market-cap. By definition, WisdomTree and Schwab, 'Do they represent the intrinsic value?', I don't think it does and I don't think it's represented that way. But the point is to try and break the link between the market cap and weights in the index."

Bryan addressed Jaffe's point that Schwab's new line isn't the best investment for the current stock market, saying, "You can't predict market direction. If you're concerned about a market correction, fundamental ETFs give you less exposure and provides protection in the aftermath of a large market correction."

Overall, Bryan said that these new funds are poised to "do better than the traditional value fund." Bryan said that the Invesco's [profile] PowerShares FTSE RAFI US 1000 is an example of a fund that has enjoyed good performance. Some of its top holdings are Exxon Mobil at 2.72 percent, Bank of America at 2.39 percent and Chevron at 1.87 percent. Its year-to-date return is 18.69 percent.

Another interesting development is that of self-indexing funds.

As IndexUniverse's Paul Amery reported, Guggenheim Investments [profile], Sigma Investment Advisors and Transparent Value Trust, requested that their registration for ETFs be exempt from certain constraints regarding transparency under the 40 Act. The orders for all three firms were sent on July 10.

Usually these firms release information on their underlying index recipe, but the S.E.C. allowed them to move forward without the usual requirements. The ruling on these three applications matters because it opens the floodgates for ETF providers to conduct business without third party indexers.

It may hurt the credibility of ETFs that don't disclose the underlying methodology, however, said S&P Capital IQ Director of ETF Research Todd Rosenbluth in an interview with MFWire. Investors choose ETFs because of, not in spite of, transparency, and may be suspicious of ETFs that don't disclose information.

"We'll see how well those efforts help gather assets," Rosenbluth said. "Some investors may not care but most investors will scrutinize something that's new. It opens the door to doing something without a third party group but time will tell if they gain traction. It's a very crowded market and someone with less transparency is at a disadvantage."

Guggenheim declined to comment on the S.E.C. ruling. 

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