By Patricia Oey
The last six months have seen over 200 new exchanged-traded products, bringing the total number of funds to nearly 1,300. Fund companies have been pushing out dividend funds, high-yield funds, and international funds in an effort to address investors' demand for income and growth. In this article, we'll discuss the risks of new exchanged-traded funds, how to pick the best ones, and then we'll highlight some interesting new launches.
Buying a New ETF
Investors need to exercise extra caution when investing in new ETFs, especially when considering niche products. A key risk is that the ETF may not behave as expected. Consider investors who rushed into United States Oil (USO) and found themselves falling far behind oil's spot-price performance. Financial innovation is often messy; no doubt many investors in new ETFs wished that they didn't volunteer to be beta testers. You can usually avoid nasty surprises by sticking to ETFs that invest in comprehensible, traditional asset classes, such as liquid, investment-grade stocks and bonds, and by avoiding bells and whistles, such as leverage and inverse performance.
Another risk is that the ETF may not gain traction, leaving you to pay unexpected capital gains or even the ETF's shutdown costs, as in the case with one now-defunct ETF family. Finally, exotic vehicles sometimes come with exotic tax implications. Unless you want to deal with the risk of a whole new set of tax schedules to file, it might make sense to hold off until you get a sense of the ETF's tax treatment.
There's also that pesky issue of liquidity. It often makes sense to let an ETF season and gain assets and liquidity. Doing so not only simplifies things for you; it's also a useful way to get a vote of confidence from the market that the ETF probably doesn't have superior competitors you may have overlooked or implementation issues. If the underlying securities of an ETF are liquid (such as U.S. equities and large-cap developed-markets equities), expect the ETF to trade at small premium and discounts and with tight spreads, even if the ETF itself is not that liquid. For products that hold less-liquid underlying holdings or international equities, it is more important to monitor the bid-ask spread, which shows how much the market "agrees" on the price of the ETF. Some ETFs can consistently trade at premiums, often indicating a less liquid asset class. Always, always use limit orders when buying new ETFs.
Investors seeking more in-depth guidance can turn to our ETF New Launch Center, where we provide short reports on each fund (available to premium subscribers) and a link to the fund's SEC filings. We have portfolio data for most of the funds on the day of launch, which can be found under the portfolio tab. Premium subscribers can also add these funds to their Morningstar Portfolio Manager, where they will be able to use the X-Ray tool to see how the addition of this fund affects their asset allocation.
Buying a new ETF doesn't have to be a nerve-racking experience. A few simple precautions, such as asking yourself whether you have a clear picture of its expected behavior and tax implications, and using limit orders, can make buying a new ETF a less costly experience.
ETFs That Deserve Consideration
While many newly launched funds are not suitable for most investors, there are a handful of ETFs we find interesting. Low volatility and high momentum are two strategies which may not be that familiar to most investors, but they have a track record of generating appealing risk-adjusted returns. While low-volatility or low-risk stocks (as measured by the standard deviation of a security's daily price returns over a certain time period) may imply steadier, lower returns, they actually outperform the market: A longer treatment of this phenomenon can be found in Samuel Lee's article Does Lower Risk Mean Higher Returns? Until April of this year, there were no low-volatility ETFs; but in May, three were launched-- PowerShares S&P 500 Low Volatility (SPLV), Russell 1000 Low Volatility (LVOL), and Russell 2000 Low Volatility (SLVY).
There are some differences between the Russell ETFs and the PowerShares ETF. The Russell ETFs hold the low-volatility members (as measured by a stock's variability in total returns based on its historic behavior over the last 60 days) of their base index (Russell 1000 or Russell 2000) at their market-cap weightings, and reconstitute monthly. We recommend waiting to see how the Russell funds perform versus its underlying index, given the monthly reconstitution (which could result in a high turnover) and the relatively high expense ratios (LVOL at 0.49% and SLVY at 0.69%). High turnover (which drives additional trading expenses for the fund) and a high expense ratio could eat into the returns of the fund.
The PowerShares ETF follows a much simpler index, which takes the 100 stocks out of the S&P 500 with the lowest volatility over the last 12 months, and weighs them by volatility (stocks with the lowest volatility receive the highest weightings). The fund is reconstituted quarterly and carries a lower expense ratio of 0.25%.
High momentum (as measured by a stock's return over a specific time period) is another strategy that has shown to outperform across almost all markets and asset classes. This strategy is also now available in an ETF structure--Russell 1000 High Momentum (HMTM) and Russell 2000 High Momentum (SHMO). These ETFs track indexes that follow the same construction methodology as the Russell Low Volatility indexes, except that they hold stocks with the highest momentum, as measured by a stock's cumulative return over the last 250 trading days, excluding the last 20 trading days. Again, we recommend watching these ETFs before jumping in to see how they perform versus their indexes. HMTM's and SHMO's expense ratios are 0.49% and 0.69%, respectively.
Russell also launched a family of investment discipline ETFs, which seek to provide exposure to different flavors of value (low P/E, dividend income, contrarian) and growth investing (aggressive growth, consistent growth, and growth at a reasonable price). Each of these ETFs track indexes apply specific screens to the Russell 1000 index. While there are existing funds that appear to be fairly similar to five of these funds, we highlight Russell Growth at a Reasonable Price (GRPC) as a differentiated product among existing growth-oriented ETFs, as it layers on a valuation screen over a growth screen. This results in a portfolio that is heavier in industrial firms and lighter in tech firms, relative to other growth funds, and a trailing 12-month P/E ratio that is more in line with the overall market. This ETF’s expense ratio is 0.37%.
ETFs that invest outside the United States have been a popular category of new launches this year, and one we find appealing is Market Vectors Germany Small-Cap ETF (GERJ). Germany tends to be underrepresented in most portfolios given its lower market cap-to-GDP ratio, relative to other large, developed economies. And when compared with the broad market iShares MSCI Germany Index (EWG), small-cap German stocks are less correlated to the S&P 500 (91% for EWG versus 85% for MSCI Germany Small Cap Index), as EWG tends to be dominated by large-cap firms that compete directly with many of the large-cap multinational U.S. firms that dominate the S&P 500. GERJ’s largest sector weightings are industrial and technology (35% and 16% of this fund, respectively)--these firms tend to be highly specialized with defendable competitive advantages. GERJ’s expense ratio is 0.55%.
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.