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Over the past few years, we’ve seen a seemingly endless array of fundamentally weighted, timeliness-seeking, dividend-focused and other specialty exchange-traded funds hit the market. Sometimes, the methodologies behind these ETFs are simple and clearly disclosed; other times, they are complete black boxes. Regardless of the methodology, however, these ETFs have been launched with the same premise: market-cap weighted indexes are inefficient because they get caught up in market bubbles; you can outperform the market by using an alternate methodology.

So… is it true?

Unfortunately, it’s still too early to say. Most of these funds have launched within the past year, and you shouldn’t stake too much on a one-year track record. (The backtested data should be largely ignored, as it is far too easy to backtest your way to strong results.)

But the recent market kerfuffle provided a nice, micro-test case of how these ETFs perform under fire. Were you better off holding one of these alternatively weighted ETFs during the market meltdown of late-February/early-March?

It depends. The table below shows the performance of 35 ETFs over the market meltdown, starting with the closing price on February 26 and ending with the closing price on March 5. The list includes a variety of dividend-weighted, fundamentally weighted, value-tilted and quantitatively driven ETFs, as well as a variety of ETFs from traditional diversifying asset classes: bonds, commodities and gold.

I use the SPDR (AMEX: SPY) ETF as the measure of the market, and compared that to ETFs focused on the broad market and/or large-cap sectors. The comparison is not entirely fair, in that each ETF represents a different segment of the market. But investors are being encouraged to swap these alternative ETFs for broad market and/or large cap exposure, so in that sense, the comparison is telling.

The study did not include all available commodity and fixed-income ETFs; instead, just a few were included as an example.

click to enlarge
specialty ETFs 1
specialty ETFs 2
specialty ETFs 3

As you can see, 19 of 34 (56 percent) alternative ETFs outperformed the SPDR. The top four performing ETFs, however, were two fixed-income ETFs and two broad-market commodity ETFs. Take those out, and the majority of alternative equity ETFs actually trailed the SPDR.

A few points jump out at me here.

One: Things Have Changed
There’s a perception that growth stocks will underperform during market pullbacks, but here, the opposite was the case: the iShares S&P 500 Growth ETF (NYSE: IVW) actually beat the iShares S&P 500 Value ETF (NYSE: IVE) by 18 basis points.

Many alternative methodologies tilt towards value, and I imagine that many investors believe this value tilt will help them if the market turns sour. But value stocks have outperformed growth stocks for many years now, and there is a lot of money tied up in “value” strategies. It’s not clear that value will have the same protective qualities in the future that it had in the past.

Critics of this position will argue that the stocks that make up “value” are always changing, so that the relative “value-ness” of the asset class doesn’t really change over time. I’m not sure that’s true anymore. In the past, “value” indexes used simple measures to divide stocks into growth and value: the S&P indexes, for instance, used price-to-book value as the sole determining factor. But over the past few years, indexers have changed their methodologies, putting a much greater emphasis on price-to-earnings ratios and forecast earnings growth. As such, value indexes are holding different stocks, and the performance of the indexes may have changed.

Two: To Diversify, Stick With Different Asset Classes
If you want diversification, stick to alternative asset classes: bonds, commodities, etc. Alternatively weighted ETFs do perform differently from market-cap weighted indexes, but not that differently. The PowerShares RAFI 1000 ETF (AMEX: PRF), for instance, trailed the SPDR by 18 basis points, while the WisdomTree Large Cap Dividend ETF beat it by 21 basis points: small potatoes during a 5 percent market turndown. Meanwhile, the iShares Lehman Aggregate ETF (fixed income) beat the SPDR by 5.5 percent, and the PowerShares DB Commodity Index won by 1.9 percent: much, much bigger differences.

Three: Gold Is Funky
In the past, gold was the first place investors turned when the market looked nervous. But look what happened during the February/March downtown: gold fell by 7.59 percent, or 2.2 percent more than the index. What gives? I’m not entirely sure.

Gold has come detached from inflation expectations, and is running on a different trend pattern. Some see it as a catastrophe hedge, and argue that the troubles in Iraq led to the strong run-up in gold. I have a feeling that there’s a momentum issue here: gold ran up after the Internet bubble as investors looked for “the opposite of stock.” As it moved, it attracted new investors, who poured money into the commodity: the streetTRACKS Gold ETF (AMEX: GLD) recently topped $10 billion in assets.

Gold's sharp pullback during the recent market contraction confirms my suspicion that momentum players are driving the price.

Four: International May Lead The Way… Down
Investors looking for diversification away from U.S. equities have in the past turned to international stocks. But as a smart advisor said to me the other day, “International has become a high beta version of the U.S.; the correlations are tightening.” Note, for instance, that the iShares MSCI EAFE ETF (NYSE: EFA) actually led the SPDR down, trailing the U.S. by 2.2 percent. The only international market that really held up well during the market meltdown was Japan, which is at a different place in its economic cycle.

Conclusion
The one-off sample is obviously not a rigorous test, but it is an interesting snapshot of the performance of these funds. Bruce Lavine, President of WisdomTree, said that he was very pleased that all of his dividend-weighted indexes beat their benchmarks during the market downturn, with one exception: the DIEFA (international) fund trailed the MSCI EAFE index because it is underweight Japan. Generally, however, it’s easy to see why dividend-weighted indexes would hold-up well in a market downturn.

(Interestingly, the PowerShares FTSE RAFI 1000 ETF (AMEX: PRF) actually trailed the S&P. PRF uses a composite of four fundamental factors to weight stocks: book value, earnings, sales and dividends. Somehow, that fundamental approach did not fair as well as the dividend approach this time.)

Overall, a few of the alternatively weighted equity funds performed well on a relative basis. But given the size of the market pullback, relative is the key worked. The Claymore/Sabrient Defender ETF, designed specifically to protect a portfolio against a market downturn, eked out a 41 basis point victory over the SPDR. That's something, but the fund still lost nearly five percent of its value in a little over a week. That’s not exactly widows and orphans performance.

Ultimately, the truth is this: if you really want protection from a broad equity market turndown, don’t buy equities; buy bonds, and maybe commodities. Different equity portfolios will perform differently, and there may be a relative performance benefit to one indexing approach versus another. Ultimately, however, if it really gets ugly, they’re all going down with the ship.

Source: Did Specialty ETFs Provide a Cushion From the Fall?