Updated Tuesday, October 21, 2014 as of 2:28 PM ET

Strategy ETFs as Alternatives?

Exchange-traded funds certainly have come a long way. SPDR S&P 500, introduced in 1993 as the first U.S. ETF, is as mainstream as can be imagined: a low-cost vehicle to track large-company domestic stocks. 

In contrast, many recent ETF launches involve strategies ranging from high beta to low volatility, which can be considered alternatives to traditional holdings. Indeed, a 2014 Russell Investments survey found that “alternatively weighted indexes” is the most popular name in North America for smart beta index products.

Can these strategy-based ETFs really serve as alternatives in a diversified portfolios? For some types, it may be too soon to tell.

“We know that ETFs based on traditional indexes work,” says Chuck Self, chief investment officer of iSectors, an Appleton, Wis.-based investment manager that provides a suite of ETF-based asset allocation models. “Many of the high beta and low volatility ETFs were started around 2011, so we don’t know how they would do in down markets such as 2007-2009. We don’t even know how these ETFs would have done in the ‘flash crash’ of 2010—how liquid would they have been?”

DIVIDEND ETFS

On the other hand, some dividend-based ETFs have been around since 2006 or earlier, so there’s more of a track record, according to Self.

“We know how they’ve performed in different market cycles,” he says. “In 2007-2009, some dividend ETFs were down less than the broad stock market. The easiest way to do well in stocks is to lose as little money as possible in bear markets.”

Consequently, iSectors has put together a suite of four dividend ETFs, including three focused on the U.S. and one holding foreign stocks. “The U.S. ETFs follow different strategies,” says Self, “so there is relatively little overlap of companies. The different ETFs might focus on high-quality companies, on high yields, or on dividend growth. Average company size varies, among those domestic dividend ETFs. The foreign stock ETF has a much higher yield, because that’s common outside the U.S., as well as a screen for profit growth.” This collection of dividend ETFs could deliver better returns with less risk than a traditional allocation to value stocks, Self contends.  

DEFINED MATURITY ETFs

On the fixed income side, Self is looking at defined maturity ETFs as an alternative to perpetual bond funds and individual bonds. Defined maturity ETFs hold a variety of bonds that all mature in a given calendar year. Thus, investors get the diversification of a fund along with the expected principal return of an individual bond, once all the ETF bonds mature.

“There are investment-grade ETFs and high-yield ETFs in this category,” he says. The latter naturally offer higher yields but also more risk than the former.

Thus, investors in defined maturity ETFs know they own a portfolio of interest-paying bonds that will pay interest for X years, with a scheduled distribution at par value at maturity. In the interim, the liquidity of an ETF provides access to cash, if needed.

“You can build ladders with them,” Self says, indicating the possibility of buying a bond ETF with a 2015 maturity, a bond ETF with a 2016 maturity, etc. “The short-term ETFs are near-cash equivalents that I can be enthusiastic about.”

 
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.

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