ETFs: Which Strategy Makes Sense in a Volatile Market?

(page 2 of 2)

The RevenueShares indexes are made up of exactly the same stocks as their nearest benchmarks but in different concentrations, based on how low a stock's price-to-sales ratio is. The large-cap ETF owns Google (GOOG) but would hold considerably less of it than the benchmark index because of Google's lofty price-to-sales multiple.

RevenueShares President Sean O'Hara cites statistics going back 30 years that show that in the 13 years when the price-to-sales ratio for the S&P 500 was above 1, the average return for the market was 7 percent, while in the 17 years when the ratio was below 1, the average return was 16.7 percent. Higher stock multiples signal that investors should lower their return expectations, he says.

For the year ended June 30, 2010, the RevenueShares Large Cap Index beat the S&P 500 by 4.47 percent and the Small Cap Index beat the S&P SmallCap 600 index by 4.18 percent; the RevenueShares Mid Cap Index underperformed the S&P MidCap 400 index by 1.0 percent. "I'm buying these shares at about half the valuation on a price-to-sales basis," says O'Hara. If your market view is negative but you think you can't afford not to be invested, "the thing to do is to figure out how to buy things at lower prices. That's what rebalancing by revenue weight does for you."

Dividend Weighting

Market and economic uncertainty are the reasons that ETF sponsor WisdomTree opted to focus on rebalancing its ETFs according to dividend weighting. "There's nothing people like more than getting dividend payments," says Jeremy Schwartz, director of research at WisdomTree, whose rebalancing process is designed to lower the valuation multiple on the basket of stocks the ETF holds. By selling stocks whose prices have risen relative to their dividend streams, an ETF tends to raise its overall dividend yield, shifting the weight from the lowest- to higher-yielding stocks, says Schwartz.

O'Hara at RevenueShares argues that weighting an index by revenue constitutes a less active bet on the market than an ETF that weights according to dividends, since so many of the stocks in U.S. indexes don't pay dividends. Similarly, weighting by earnings would have knocked out most of the big financial firms such as Citigroup (C) in late 2008 and the first half of 2009, when they had massive asset writedowns but were still viewed as bargains. But globally, a much higher percentage of stocks pay a dividend, so weighting by dividend isn't nearly as exclusive, says Schwartz.

Windward, which is currently 100 percent invested in ETFs, has looked into dividend- and price-to-book-value-weighted ETFs but decided the performance data weren't compelling enough to justify moving away from market-cap-weighted funds. "We're not convinced you're saving enough on valuation [for it to be worthwhile]," says Elan. "ETFs using something other than a cap-weighted index are a little more expensive and would have that hurdle to get over" in order to generate higher returns.

Windward relies on asset-allocation shifts to provide clients with downside protection. Its most conservative portfolio has only a 15 percent weight in equities now, while the most aggressive strategy has a 40 percent exposure to stocks. Since April, when volatility spiked, Windward has increased its exposure to gold ETFs and continues to be heavily invested in bonds through Barclays iShares ETFs holding one- to three-year (SHY) and seven- to 10-year U.S. Treasury notes (IEF), Treasury Inflation-Protected Securities (TIP), and the Barclays Aggregate Bond index (AGG), which includes corporate bonds and mortgage-backed securities.

Actively Managed ETFs

While the vast majority of ETFs are tethered to a benchmark index, actively managed ETFs are gaining more prominence. The U.S. Securities & Exchange Commission defines actively managed ETFs as ones that don't seek to track the return of a particular index. So far, there are just a handful of actively managed ETFs available. AdvisorShares, which specializes in these upstart ETFs, is launching two new ones this month.

Like their passive cousins, actively managed ETFs offer transparency, tax advantages, and lower fees—all features that retail investors are increasingly demanding. And from the perspective of fund sponsors, the main draw is wider distribution to investors than a fund manager could get with a mutual fund.

Noah Hamman, AdvisorShares' chief executive officer, likens the ETF structure to iTunes, which lets an unknown local band post a song, attract a following, and compete directly with Madonna or any other mainstream pop icon. "There are no barriers. You're truly competing with [larger fund firms] on a quality basis," he says. It's a way to avoid being dependent as a mutual fund on a brokerage platform such as Charles Schwab (SCHW) or Fidelity for distribution to retail investors, he adds.

The strategy behind AdvisorShares' Dent Tactical ETF (DENT) was designed "specifically for this economic season," says Rodney Johnson, co-manager of the fund, which invests in a wide range of ETFs. Johnson says he and his co-manager Harry Dent Jr. had long been forecasting a prolonged period of economic contraction to start in 2008.

Switching Asset Classes

In a market that's expanding, getting in and out of positions is counterproductive, while in a contracting market there's more risk than return opportunity in a buy-and-hold approach "because you get these sudden drops where you're just holding on and watching it drop away," Johnson says. His fund has the latitude to invest in international stocks, sectors such as technology, or commodities, all through ETFs designed to hold those asset classes. On Friday, June 25, with the ETF invested 80 percent in equities, his model signaled it was time to get out and the following Monday he switched to 70 percent cash, narrowly avoiding a quarter-ending slump in equity markets around the world.

There's still a lot of resistance among ETF fans to a more actively managed product. Investors seeking active managers who they believe can beat an underlying benchmark should stick to mutual funds, says Windward's Elan. It's not to an ETF manager's advantage to reveal to other market participants where he's over- and underweight an index on a daily basis, or what his trading strategy is, as actively managed ETFs are required to do, because he runs the risk of being front-run or copied by other investors, says Elan. That only dilutes any edge a manager hopes to gain over the market, he adds.

But as long as the market offers elevated volatility and more uncertainty, the option of easy exits and entries, lower taxes on gains, and lower management fees is likely to be of increasing interest to the average retail investor, who may be growing increasingly wary of the stock market's gyrations.

Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

Business Exchange

Track and share business topics across the Web.