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Many investors point to the rise of the ETF industry as a clear shift in preferences away from relatively expensive active management in favor of low-cost indexing. It’s been said that the alpha hunters have evolved into beta grazers. But the benefits of the ETF structure aren’t reserved solely for passive cap-weighted products, and the last few years have seen a huge increase in the number of ETFs that blur the lines between active and passive management.

While the vast majority of ETF assets are invested in beta funds that track widely-followed equity and fixed income benchmarks (such as the S&P 500 (SPY) or the MSCI Emerging Markets Index (EEM)), there are a number of funds that track non-traditional “intelligent” indexes. These benchmarks are typically constructed using various proprietary quantitative methodologies that aim at achieving excess returns by identifying securities poised to outperform the broader markets and experience above-average capital appreciation.

These ETFs represent a type of hybrid investment. They are designed to track a specified index, but the underlying index is generally more complex than, for example, the market capitalization-weighted S&P 500. There are dozens of these “alpha-seeking ETFs” now available, including size and style-based funds and sector-specific ETFs.

From a performance perspective, the results have been mixed. Some have trailed behind more conventional, while others have displayed an impressive ability to deliver excess returns. Below, we profile seven of the most impressive. (It should be noted that none of these products are actively-managed–they’re all designed to replicate the performance of an underlying index. Rather, it is the indexes to which these products are linked that implement various strategies in an attempt to deliver excess returns relative to traditional broad-based benchmarks.)

7. PowerShares Dynamic Large Cap Value Portfolio (PWV)

PowerShares bills itself as the leader of the “intelligent ETF revolution” and its product line includes a number enhanced index “Dynamic” ETFs. The Dynamic index methodology is designed to evaluate stocks on their investment merit, using quantitative analysis to identify those with the greatest potential for capital appreciation. Moreover, the Dynamic indexes utilize a tiered-weighting methodology that mitigates the risk of significant concentration in a few mega-cap stocks.

PWV is based on the Dynamic Large Cap Value Intellidex Index, which is designed to select companies poised to outperform broad market benchmarks while “maintaining consistent stylistically accurate exposure.” Since its launch nearly five years ago, PWV has gained about 21%. Over the same period, the Russell 1000 Value Index Fund (IWD) and S&P 500 Value Index Fund (IVE) are both in the red, having lost about 8% and 9%, respectively.

6. First Trust Large Cap Value Opportunities AlphaDEX Fund (FTA)

PowerShares’ primary competitor in the “enhanced” index ETF business is First Trust, the issuer known for funds based on the AlphaDEX methodology. The AlphaDEX products rely on a multi-factor quant model to rank potential constituent stocks, and use a system that gives the highest weighting to the highest ranked stocks (more on this methodology below).

Since its inception in May 2007, FTA has lost about 23% of its value, not an impressive profile on a stand-alone basis. But for buy-and-hold investors, the ability to minimize losses in bear markets is just as valuable as the ability to deliver enhanced positive returns in bull markets. Over that same period, the iShares S&P 500 Value Index Fund (IVE) lost nearly 32%, a gap of about 900 basis points to the First Trust fund.

5. PowerShares FTSE RAFI Developed Markets ex-U.S. Small-Mid Portfolio (PDN)

In addition to its line of Dynamic ETF products, PowerShares offers a handful of funds that utilize fundamentals-weighting methodologies to construct benchmarks. Where as most indexes are based on market capitalization weightings, the FTSE RAFI index series uses a weighting structure that considers four fundamental measures of size: sales, cash flow, book value, and dividends.

The rationale for this methodology is pretty simple. Market capitalization-weighted benchmarks will increase the allocation to stocks as the share price rises, creating the potential to overweight overvalued stocks and underweight undervalued stocks. This occurrence is more than just a hypothetical: at the height of the tech bubble, the technology sector represented over 35% of the S&P 500, setting investors up for big losses in the ensuing correction. By breaking the link between price and portfolio weight, fundamental indexes prevent the market from dictating the weight given to a stock in a particular index.

Since the beginning of 2008, PDN is down about 13%, while SCZ, which tracks the MSCI EAFE Small Cap Index, has lost nearly 30% over that period.

4. Claymore/Zacks Mid-Cap Core ETF (CZA)

Claymore also dabbles in quantitative methodology ETFs, partnering with index providers who develop benchmarks with the potential to outperform traditional cap-weighted indexes. CZA is based on the Zacks Mid-Cap Core Index, which seeks to select a group of about 100 securities with the potential to outperform the Russell Midcap Index or S&P MidCap 400 Index. Zacks uses a proprietary methodology to determine these holdings, and rebalances holdings on a quarterly basis.

Since it launched in April 2007 CZA has slipped by about 7%, but has beaten the MidCap SPDR (MDY) and Russell Midcap Index Fund (IWR) by about 6% and 12%, respectively.

3. ProShares Credit Suisse 130/30 (CSM)

ProShares is best known in the industry as the pioneer behind leveraged and inverse ETFs, but the issuer has also introduced a product that aims to outperform an index benchmark by taking advantage of negative and positive expectations for stocks. The concept of 130/30 investing is nothing new–institutional investors have been employing this technique for years–but its availability in the ETF structure is a relatively recent development.

The methodology behind a 130/30 strategy is relatively simple, and includes the use of limited leverage. First, 30% of the portfolio is sold short, and the proceeds are used to establish long positions equal to 130%. The net result is 100% market exposure (read more about 130/30 investing in this feature). The difficulty obviously comes in identifying overvalued stocks to short and undervalued stocks on which to “double down.”

The universe of eligible securities for the Credit Suisse 130/30 Index includes the 500 largest U.S. stocks, so it is logical to compare CSM’s performance to SPY. CSM is still a relatively new product, but early results are impressive: since its launch in July 2009, CSM has beaten the S&P 500 SPDR by about 160 basis points.

2. First Trust Health Care AlphaDEX (FXH)

A number of First Trust’s AlphaDEX products have outperformed cap-weighted counterparts in recent years, but perhaps the most impressive in the health care fund. FXH is linked to the StrataQuant Health Care Index that determines holdings in a multi-step process. First, Russell 1000 stocks contained in the health care sector are ranked on growth factors (three, six and 12-month price appreciation, sales to price and one year sales growth) and value factors (book value to price, cash flow to price and return on assets). The bottom 25% is eliminated and the top 75% is selected for the index.

The stocks that are selected are further split into quintiles based on their ranking, with the top ranked quintile receiving a larger weight within the index. Stocks are equal-weighted within each quintile.

Since its launch in May 2007, FXH has gained about 10%. By comparison, the Health Care Select Sector SPDR (XLV) and Dow Jones U.S. Health Care Index Fund (IYH) have lost 10% and 7%, respectively, over the same period.

1. Claymore/Zacks Dividend Rotation ETF (IRO)

Another collaboration between Claymore and Zacks has delivered some impressive results recently. IRO is based on an index that seeks to maximize dividend income that qualifies for taxation at the lowest current tax rates by selecting dividend-paying stocks based on a proprietary quantitative methodology.

Since the beginning of 2009, IRO has gained nearly 50%. By comparison, DVY, which tracks the Dow Jones U.S. Select Dividend Index, is up just 12% over the same period.

Disclosure: No positions at time of writing.

Source: 7 Alpha-Seeking ETFs That Have Crushed Their 'Benchmarks'