It's not easy these days to find anyone who's bullish on equities. It's not just that the broad U.S. stock market dropped 10 percent in the second quarter. The flow of disheartening data on jobs, home sales, retail sales, and consumer sentiment in recent weeks has seriously eroded investor confidence.
To the extent that investors want to stick with higher-yielding—and necessarily higher-risk—assets, exchange-traded funds and notes (collectively, ETFs) may be their best bet, some believe. They are an ideal vehicle to achieve diversification across broad indexes as a hedge against elevated market volatility, according to David Elan, a principal at Windward Investment Management in Boston.
"It may mean holding a fair amount of cash in your portfolio," via either short-term U.S. Treasury notes or Treasury Inflation-Protected Securities (TIPS) in an ETF format, he says. "The advantage would be if you decide you want to change your allocation very quickly—if you're using mutual funds, you're subject to a short-term redemption fee and that wouldn't be the case with ETFs." He adds that ETFs may also be the best way to hold gold or other commodities in your portfolio as a hedge against volatility, in lieu of longer-dated Treasury bonds.
Until a couple of years ago, you would use ETFs because you believed it was extremely hard, if not impossible, to consistently outperform the market and, as a result, paying anything more than minimal fees lowered your total returns. The tax efficiency inherent in ETFs was a nice bonus that would also enhance your returns. Now there's a wider spectrum of choices within the ETF universe.
The traditional ETF simply tracks a chosen underlying benchmark index—like the Standard & Poor's 500-stock index for large caps or the Russell 2000 index for small caps—and replicates the market-capitalization weighting within the index. If you like this kind of ETF, you tend to believe that the market is an efficient pricing mechanism and that stocks are mostly fairly valued.
Over the last five years, the S&P 500 has beaten 60.8 percent of actively managed large-cap U.S. equity funds, while the S&P MidCap 400 index has outperformed 77.2 percent of mid-cap funds and the S&P SmallCap 600 index has outperformed 66.6 percent of small-cap funds, according to the latest Standard & Poor's Indices Versus Active Funds Scorecard, released in March 2010. The results for active managers are better or worse when comparing performance by fund style. The S&P 500 Growth index beat 76.9 percent of all large-cap growth funds and the S&P 600 SmallCap Growth index outpaced 77.8 percent of small-cap funds over the past five years. Value funds fared better, with the S&P 500 Value index beating just 38.8 percent of large-cap value funds and the S&P 600 Value index beating 48.8 percent of small-cap value funds.
But these days, market cap isn't the only game in town. Strictly speaking, ETFs that use weighting systems other than market cap are not actively managed. Fundamentally weighted ETFs—which use criteria such as revenue, dividends, or earnings in composing the portfolio—"are expressing an opinion about the market one way or another that's different than the pure market-cap weighting," says Dave Nadig, director of research at IndexUniverse.com, a fund information website. It's fair to call such products "alpha seeking" since they're trying to beat a market-weighted index, but they're still considered passively managed because they follow a rule book, he says.
Paoli (Pa.)-based asset manager RevenueShares offers six funds, each of which passively tracks an index but rebalances once a year based on revenue weight instead of market-cap weight. The Revenue Weighted Large Cap Index's top 10 holdings currently include just five of the top 10 names in the S&P 500 as ranked by market cap. Wal-Mart (WMT), the biggest contributor to the S&P 500's total revenue at 4.74 percent, isn't among the S&P 500's top 10 holdings based on market cap, while Apple (AAPL), ranked second in the S&P 500 by market cap, isn't among the Revenue Weighted Large Cap index's top 10.
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