MarketGrader Hopes To Bring Past Outperformance To the ETF Market

ETF investors have watched a wave of "beat the market" ETFs launch over the past year. PowerShares, WisdomTree, Rydex, First Trust ... everyone, it seems, has an idea how to beat the market.

But alpha-seeking investors got a new and interesting set of tools today when a company called SPA ETF Plc launched six ETFs tied to the MarketGrader family of indexes on the American Stock Exchange.

The strategy uses quantitative, fundamentals-based analysis to identify stocks it thinks will outperform the broader market. So far, so familiar.

But the MarketGrader indexes differ from other "beat the market" strategies in a couple of ways. For one, they have a real-time track record: the indexes have been up and running since 2003. And so far, the real-time performance has been strong: Over the past three years, all six MarketGrader indexes have outperformed the S&P 500, S&P 400 and S&P 600 by a wide margin.

More importantly, however, the MarketGrader indexes are focused indexes; the flagship index is the MarketGrader 40, which holds just 40 equally-weighted stocks, weighted equally. That creates a high volatility portfolio that risks underperforming the market by a large measure... but also holds out the possibility of beating the market by a wide margin as well.

Other beat-the-market strategies hold hundreds or thousands of stocks, and position themselves as alternatives to cap-weighted indexes. The MarketGrader indexes are better thought of as stock-picking portfolios, sharing more in common with actively managed funds like the Janus 20 than the Russell 1000 or the S&P 500.

The strategy may be familiar to readers, as it was selected recently by Barron's magazine to underlie its new flagship "stock-picking" index, the Barron's 400.

The new ETFs charge 0.85% in expenses, among the highest fees in the ETF market; SPA ETF hopes that the performance more-than-justifies those expenses.

"We have found in MarketGrader a fundamentally based methodology system that has a solid performance history, and we are confident that this will provide investors with an investment tool that will stand out among this growing market," said Daniel Freedman, Director, SPA ETFs Inc.

"These are not passive indexes by any stretch of the imagination," said Tony Drain, President, SPA ETFs. "If you look at the performance on all six strategies going back to 2003, it is quite impressive."

SPA ETFs encountered the MarketGrader indexes a few years ago when its parent company, London and Capital, was looking for ways to improve the performance of its own managed portfolios, says Edward Feliciano, Director, SPA ETFs.

"We came across MarketGrader and realized that, not only could it help our portfolios, it could also help other asset managers and investors looking for better performance. So we started working with MarketGrader to develop financial products off the back of it."

London & Capital has offered notes linked to the MarketGrader 40 index in London for over two years.

The MarketGrader system looks at 24 quantitative indicators, roughly divided into four buckets: growth, value, profitability and cash flow. The indexes have certain capitalization and sector restrictions to ensure that no one area of investing dominates an index. For instance, the MarketGrader 40, 100 and 200 indexes are required to have a 25% minimum position in large caps and a 25% maximum position in small caps.

"If you're a fundamental analyst, you're looking at these same factors," said Drain.

The large-cap, mid-cap and small-cap indexes hold the 100 highest-rated stocks in each capitalization segment.

Turnover can be an issue for the indexes. The MarketGrader 40, for instance, has an average annual turnover of 50%. That compares poorly with most benchmarks, but is lower than most actively managed funds.

Like other "beat-the-market" ETFs, these products will have to be sold to investors, and SPA ETFs faces a serious task of reaching out to wholesalers and convincing them that the strategy is sound.

Written by Matthew Hougan