Beyond Income: Examining Popular New ETF Launches And Their Underlying Strategies

by: Morningstar

By Robert Goldsborough

With United States equity markets near record highs, the U.S. economy regaining strength, unemployment slowly declining, and interest rates finally on the rise, investors sit at something of a crossroads.

U.S. equity market valuations are expensive, but interest rates remain near historic lows. For investors with cash on their hands, these are daunting times. What are some of the more compelling investment opportunities available to investors? One possible source of ideas comes from recent exchange-traded product launches, which continued unabated, as ETP providers have debuted 100 ETPs in 2013 alone.

ETP launches sometimes are a trailing indicator, as it usually takes a minimum of several months between product registration and roll-out. Still, ETP issuers endeavor to create products they think will gain traction from investors, so a look at successful recent product roll-outs can offer a sense of where providers have done a solid job of anticipating investor interest. Interestingly, while ETP providers continued to roll out product after product devoted to offering investors income in this low-rate environment--some of the most popular areas continue to be master limited partnerships and multiasset portfolios--most of the most successful ETPs have not had an offer of more income as their cornerstone.

Rates, Rising
Somewhat surprising is the relative dearth of products rolled out this year are aimed at protecting investors from rising rates. (Several ETF issuers recently have placed products in registration with the SEC that would address this issue.) However, for investors concerned about rising rates, a few new useful products have launched.

Some of the most popular new launches that offer protection against rising interest rates are in the bank-loan ETF category, where two actively managed funds recently debuted. Bank-loan ETFs offer access to floating-rate loans, which have the potential to protect against rising rates. This can offer some nice diversification for a bond portfolio away from fixed-rate bonds, which dominate most investors' portfolios. The dominant bank-loan ETF long has been the passively managed PowerShares Senior Loan Portfolio (NYSE:BKLN), which rolled out in early 2011 and now has more than $5.5 billion in assets. However, several actively managed bank-loan ETFs have rolled out over the past few months and have had success drawing assets, including SPDR Blackstone/GSO Senior Loan ETF (NYSEARCA:SRLN), which charges 0.90%, and First Trust Senior Loan (NASDAQ:FTSL), which costs 0.85%. (By contrast, BKLN charges 0.66%.) As interest rates have risen, bank-loan ETFs have performed exactly as one might expect, with rising rates having very little effect on the price of bank loans, whose portfolio duration (a measure of interest-rate sensitivity) tends to be very close to zero.

See Why Everyone's Talking About ... Europe?
The European economy has been plagued by uncertainty over the past several years. Unemployment is high, fiscal imbalances in Spain and Italy threaten to drag down the rest of the eurozone, and austerity measures could hinder demand for a long period to come.

At the same time, investment banks that issue exchange-traded notes have shown an interest in European stocks--particularly high-quality ones. We believe investors are looking to European blue chips right now because they are the most compelling story in what is a fairly uninspired global equity opportunity set, with decent dividends and reasonable valuations. And what's more, those who sit around waiting for improving data to finally show up in economic data may miss much of the upside from an eventual European-stock rebound. Remember: Stock markets are leading indicators.

For investors seeking exposure to European equities, the U.S. ETP marketplace already has several strong options in the very low-cost Vanguard FTSE Europe ETF (NYSEARCA:VGK) (0.12% expense ratio), the much higher-priced iShares Europe ETF (NYSEARCA:IEV) (0.60%), and the concentrated and high-quality SPDR STOXX Europe 50 (NYSEARCA:FEU) (0.29%). Now, in recent months, two banks have rolled out ETNs offering double-leveraged exposure to the same 50 European blue-chip companies found in FEU, which tracks an index drawing its constituents from the STOXX Europe 600 Index. Barclays ETN+ FI Enhanced Europe 50 ETN (NYSEARCA:FEEU) has amassed more than $875 million in assets in just a few short months, and Credit Suisse FI Enhanced Europe 50 ETN (NYSEARCA:FIEU), which tracks the same index, already has more than $50 million in assets since rolling out early this month.

While we generally don't recommend that most investors consider leveraged ETPs—especially not as a long-term buy-and-hold investment--these two ETNs' rapid asset growth suggests to us that there is considerable interest among investors in gaining supercharged exposure to European stocks.

Bonds Around the World
Although interest rates remain low on an absolute basis, Vanguard recently filled in a hole not just in its own product suite but in the ETP market as a whole, with the roll-out in late May of a broad-based ETF holding investment-grade corporate and government debt issued around the globe. Vanguard Total International Bond Index Fund (NASDAQ:BNDX), which also has a mutual fund share class, entered a surprisingly thin field of broad international bond ETFs. There are a handful of non-U.S. bond ETFs devoted to government debt and a few others holding solely corporate debt. There also are plenty of single-country bond ETFs and emerging-markets-only bond ETFs. However, there are no ETFs with as broad of a foreign-bond mandate as BNDX.

Thus far, investors have embraced BNDX, placing more than $550 million in the new fund. A word of caution: While the fund can offer portfolio diversification relative to a U.S. bond ETF, it has a heavy weighting to Japanese debt, which makes up fully 22% of its assets.

Finally, Factors
Over the past few months, iShares has rolled out a suite of four factor-based ETFs that attempt to tap into quality, size, and value factors, all of which academic and industry research show can result in outperformance relative to the broader market.

The size and value risk premiums have been well-documented, while the presence in a portfolio of quality companies--those with lower leverage, minimal earnings variability, and higher earnings quality--also has been found to influence and enhance returns.

With that in mind, iShares is using MSCI indexes with mechanical criteria aimed at building a portfolio of U.S. companies that can exploit these factors. IShares MSCI USA Quality Factor (BATS:QUAL), for instance, tracks an index that selects stocks with high returns on equity, low debt/equity ratios, and low variability in their year-over-year earnings per share growth over the past five years, while iShares MSCI USA Momentum (BATS:MTUM) seeks to replicate a benchmark that employs a formula that identifies companies with strong price momentum over the trailing six- and 12-month periods.

Meanwhile, iShares MSCI USA Size Factor ETF (NYSEARCA:SIZE) tracks an index that gives higher weights to companies with small market caps and lower risk weightings, while iShares MSCI USA Value Factor (BATS:VLUE) aims to replicate a benchmark of companies that would be classified as value stocks, based on metrics like book value.

All four new funds charge 0.15%.

Right now, the majority of the assets currently invested in these four ETFs is seed capital from the Arizona State Retirement System, which seeded each of the funds with $100 million. It will be interesting to see if a broader set of investors embraces these strategies.

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