Quant ETFs vs. the S&P 500: Outsized Returns But Be Careful

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Includes: IVV, NFO, PRN, PWV, SPY, XRO
by: Tom Lydon

With more than 1,000 products on the market, you’ll find all sorts of ETFs to mimic different investment strategies. One of the newer types is quantitative index based ETFs that promise high-octane returns.

Two primary characteristics of ETFs are that they:

  • track the holdings and performance of a defined “index” of securities; and
  • enable investors to cost-efficiently purchase such an index as a single basket of securities, which can be bought and sold like a stock.

Typically, indexes are designed to track the average performance of a group of stocks. In order to do so, they are weighted by a couple of different methods, with the most prominent one being the market-weighted method, Scott Martindale of Trading Markets explains.

However, as markets rise, the cap-weighted indexes tend to overweight large companies at the expense of smaller ones. In response, enhanced indexing has curried favor recently.

“The goal [of enhanced indexing] is to identify a subset of stocks from within a traditional broad-based index that exhibit certain key characteristics, providing the greatest potential for capital appreciation.”

The second level of enhanced indexing, or quantitative indexing, looks at a wider variety of factors that include fundamental, technical and sentiment-oriented characteristics (e.g. insider buying, put/call options activity).

This type of indexing relies on playing by rules, says Elizabeth Trotta for Smart Money. These ETFs tend to do well in markets that are consistently moving up or down. In choppy markets, though, they’re not as easy to pin down.

The first level of enhanced indexing looks at fundamental characteristics such as book value, cash flow, earnings and dividends.

Below is a list of a few quant ETFs and their performance against the S&P 500.

ETF Inception Date Total Return Since Inception Thru 12/31/07 Total Return S&P 500 Thru 12/31/07
PowerShares Dynamic Large Cap Value Portfolio (NYSEARCA:PWV) 3/3/05 41.5% 21.3%
PowerShares Dynamic Industrials Sector Portfolio (NYSEARCA:PRN) 10/12/06 20.6% 7.7%
Claymore/Zacks Sector Rotation Portfolio (NYSE:XRO) 9/21/06 30.9% 12.9%
Claymore/Sabrient Insider ETF (NYSEARCA:NFO) 9/21/06 18.8% 12.9%
Click to enlarge

As with any ETF, use caution and have a strategy. Just because these funds in the long-term have outperformed the S&P 500 doesn’t mean that they always will. A simple strategy we use is trend following, which you can read about here.

Sumin Kim contributed to this article.

Disclosure: None