By Samuel Lee
The Case for Unpopular Indexes
Investors rightly associate size with stability and low costs, but rigidly sticking to giant ETFs can lead investors astray. Flawed index construction can overwhelm the expense ratio and liquidity advantage big ETFs enjoy. Some of the biggest funds, such as those following the S&P 500 and Russell 2000, lose a lot of money to front-running arbitrageurs.
Active ETF investors should be wary of so-called enhanced ETFs that attempt to beat the market, especially when they get bloated with assets. Like active managers, even the best active indexes have limited space to execute their strategies. It's hard enough as it is to earn alpha--saddling a previously outperforming index-based strategy with too many assets can wipe out the mispricing it exploits. Almost by definition, the best-returning strategies will usually be ones that had limited capital dedicated them.
Active or passive, ETF investors can reap rewards by venturing off the beaten path and either avoiding unnecessary but hidden costs, or improving their chances of finding unexploited opportunities.
With over 1,200 exchange-traded funds, we figured a few good ideas were bound to slip through the cracks. So, we dug for treasure among the 1,000 ETFs that haven't passed $1 billion in assets and found a few gems that could supplement your portfolio.
United States Commodity Index (USCI) - $453.7 million
Futures-based commodity index investors have been hurt by a one-two punch of contango and price impact. Contango dragged some long-futures-based funds down by 10 percentage points or more. To add insult to injury, they've lost about 3% annualized over the past decade to price impact, according to a recent paper by Columbia University professor Yiqun Mou.
USCI cleverly sidesteps much of these issues by exploiting backwardation (the opposite of contango) and momentum. Yale professor K. Geert Rouwenhorst and his partners at SummerHaven designed the index based on their academic research. It's rare for an active-strategy ETF to have such intellectual firepower behind it.
In a dramatic vindication of Rouwenhorst's research, the fund has outpaced every broad commodity ETF by an average of 8% since its launch last August, and its outperformance came from consistent monthly gains rather than a few anomalous periods. If you must have long futures-based commodity exposure, get this fund.
WisdomTree SmallCap Dividend (DES) - $243.0 million
Small beats large and value beats growth--at least, that's how it's been in virtually every stock market studied. Whether it's a reward for risk or a mispricing, small-value stocks have trounced the market, and most researchers agree that they should have higher expected returns than the broad market. This ETF is a fine way to gain exposure to the smallest, most value-loaded stocks in the U.S. without verging into explosive microcaps (which are fraught with their own risks). The fund buys the most boring companies in the U.S. by screening for dividend payers.
The fund did poorly over the past few years. But is it due to flawed implementation? The Carhart model, the academic standard for performance attribution, says not: Its poor performance relative to vanilla small-value indexes was due to deeper size and value tilts.
Vanguard Global ex-U.S. Real Estate ETF (VNQI) - $132.2 million
Vanguard's new global real estate offering is the cheapest and most diversified global real-estate ETF on the market. Real-estate investors should look into this fund, which offers access to the 70% of the real-estate market left out by U.S. REIT funds. International real-estate funds have not enjoyed broad acceptance, with total ETF assets slightly under $3 billion, versus close to $17 billion in U.S.-focused ETFs. Unlike U.S. REITs, international real-estate companies have not recovered their pre-crisis peaks, yet boast high yields, leaving them with potentially attractive valuations.
This REIT fund has several key advantages over its main competitor, SPDR Dow Jones International Real Estate (RWX). It charges a 0.24% lower expense ratio, holds nearly four times as many stocks, and includes a dose of emerging-markets exposure.
PIMCO Build America Bond Strategy (BABZ) - $30.7 million
Build America Bonds, or BABs, and PIMCO's actively managed ETF have been largely ignored by retail investors. Congress created the BAB program in 2009 as part of its stimulus bill to subsidize municipalities borrowing money for infrastructure projects. BABs trade at discounts to equivalently rated corporate bonds in part because they're more illiquid. As of writing, BABZ's estimated yield to maturity is 6.74%. It's also cheaper than virtually all other actively managed BAB funds. With reputable active managers and institutional-level pricing, it's a bit of a mystery why this ETF hasn't caught on.
Credit Suisse Merger Arbitrage Liquid Index ETN (CSMA) - $61.5 million
If you subscribe to the ETFInvestor newsletter, you've probably read my articles excoriating alternative ETFs for repackaging common risk tilts, or betas, slapping on a higher expense ratio, and selling them as alpha products. So why am I suggesting CSMA? Imagine you own stock of a company that's just been revealed as an acquisition target; its price rockets up, but hovers a few dollars below the acquisition price. You'd probably sell out to lock in your gains. After all, deals sometimes fall through. Merger arbitrage profits are the reward for acting as an insurer for the acquisition stock holders. It's what's known as an alternative beta. There's no real trickery involved here, no promise of stupendous safe returns. You're paid for bearing risk. Until very recently, the only way to access this alternative beta was by overpaying hedge funds, which often use leverage to justify their fees. CSMA costs a reasonable 0.55% annually.
The benefit of merger arbitrage is that its returns are largely uncorrelated with the market. Adding a small dose to your portfolio can improve risk-adjusted returns, even if its annual returns aren't awe-inspiring. This recommendation is for the more daring investors out there. There are two major caveats: It's an ETN, so it bears credit risk, and merger arbitrage strategies become moderately correlated to the market during vicious bear markets.
Buying an Unloved ETF
Unloved ETFs can have low liquidity, so investors should always trade them with limit orders. Post limit orders at close to net asset value, or NAV, which you can look up in real time by typing the ETF's ticker into Morningstar.com's quote box with the suffix ".IV" (so "VTI.IV" for the Vanguard Total Stock Market ETF's real-time NAV). When they see a large limit order near NAV outstanding, market makers will go out and either acquire or create the shares to sell to you. With a little care, venturing into smaller ETFs doesn't have to be a costly experience.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.