Newly Launched ETFs That Screen for Quality

by: Morningstar

By Patricia Oey

As of April 26, 116 new ETFs or ETNs have been launched in 2011 (reports on recently launched exchange-traded funds can be found in our ETF New Launch Center). Not surprisingly, the ETFs garnering the most assets are the ones that are the first ETFs to market for a particular asset class, such as WisdomTree Asia Local Debt ETF (NYSEARCA:ALD) ($222 million), Vanguard Total International Stock Index ETF (NASDAQ:VXUS) ($106 million), PowerShares Senior Loan Portfolio (NYSEARCA:BKLN) ($103 million), and WisdomTree Managed Futures (NYSEARCA:WDTI) ($95 million). The rapid growth in size of these funds reflects the attractiveness of the ETF structure across asset classes.

The remaining new launches in 2011 are a broad mix, including subsector or theme ETFs, leveraged and inverse fixed-income ETFs, international equity and bond ETFs, and commodity ETNs. Among these, we want to highlight the following funds, which employ screens that attempt to create higher-quality portfolios, relative to existing similar products.

Last week First Trust launched nine international ETFs that track AlphaDEX indexes, a type of fundamental-factor index. We like these offerings because the underlying fundamental indexes for these funds first screen for higher-quality companies by using value and growth factors, and then apply a modified equal-weighting to the selected names. Fundamental indexes such as AlphaDEX have been able to generate excess returns relative to their respective capitalization- weighted benchmark indexes, most of the time. Among First Trust's existing nine sector ETFs and seven style and size ETFs, fourteen of them have outperformed their benchmark on a three-year annualized basis through the first quarter of 2011.

These new First Trust international ETFs also remedy the single stock or sector overweightings that are common in some international markets, such as Brazil and South Korea. In the popular cap-weighted iShares MSCI Brazil Index (NYSEARCA:EWZ), oil firm Petrobras accounts for 20% and mining company Vale (NYSE:VALE) accounts for 15%. In the First Trust Brazil AlphaDEX (NASDAQ:FBZ), no single stock accounts for more than 4% of the fund. This Brazil fund and First Trust South Korea AlphaDEX (NASDAQ:FKO) and First Trust China AlphaDEX (NASDAQ:FCA) are the first ETFs to offer non-cap-weighted exposure to these three markets.

In addition to a handful of single-country offerings, First Trust also launched First Trust Emerging Markets AlphaDEX (NYSEARCA:FEM) and First Trust Developed Markets ex-US AlphaDEX (NYSEARCA:FDT). This will be the third family of fundamentally weighted international funds, the first two being WisdomTree's dividend-oriented ETFs and PowerShares RAFI ETFs. While the WisdomTree and RAFI funds tend to have a more value tilt, the AlphaDEX funds screen on both value and growth factors, which includes a screen for momentum--three-, six-, and 12- month price appreciation. Academic research has shown that momentum strategies work in both U.S. and international markets, and that momentum tends to do well when value is underperforming, and vice versa. The AlphaDEX funds attempts to benefit under both market conditions.

Another non-cap-weighted alternative for emerging markets is SPDR S&P Emerging Markets Dividend ETF (NYSEARCA:EDIV), which is currently yielding about 5%. This fund weighs its 100 constituents by annual dividend yield and attempts to reduce its exposure to companies with unsustainably high yields by screening for firms that have a positive three-year earnings growth and profitability. A dividend-oriented strategy in emerging markets has done well, as evidenced by the performance of WisdomTree Emerging Markets Equity Income (NYSEARCA:DEM). DEM's three-year annualized returns of 8% blow away the returns of the MSCI Emerging Market Index of 1.8%. The main difference between EDIV and DEM is that EDIV has a heavy 19% exposure to utilities (versus DEM's 9%), a sector that should provide some stability to the fund, as well as exposure to local economic growth.

Turning to U.S. equities, we would like to highlight iShares High Dividend Equity (NYSEARCA:HDV). While many dividend ETFs use quantitative screens for quality, this ETF also employs both a quantitative screen, as well as a qualitative screen. The former assesses a company's distance to default (which is based on a firm's balance sheet and stock market volatility), and the latter assesses a company's sustainable competitive advantage. For those familiar with Morningstar's stock-research methodology, the qualitative screen of this fund utilizes Morningstar's moat ratings, and as such, almost all the holdings have either a wide or narrow moat. Among the companies that pass these two screens, the fund will then select the 75 highest-yielding stocks and then weighs them by dividends paid, which tilts the fund toward large-cap value stocks. This fund has a lower weighting in financials but a higher weighting in health care than most dividend funds.

Disclosure: Morningstar, Inc., receives fees for licensing its indexes to ETF/ETN providers. These fees are mainly based on fund assets under management. BlackRock Asset Management (iShares); First Trust; ELEMENTS; Invesco (PowerShares); and Scottrade (Focus Shares) currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.