Many investors are familiar with exchange-traded funds (ETF) by now. ETFs provide broad market exposure through index-tracking investments, and they trade on exchanges like stocks do. They tend to be less expensive to own than mutual funds and have a tax efficient structure. For these reasons, total assets managed by ETFs reached 2 trillion dollars during 2014. Recently, we’ve seen an increased level of innovation within the ETF space. While it’s debatable whether these innovations will improve long-term performance results, they provide some interesting choices and considerations for investors.
One broad group of ETFs that’s growing in popularity is the so-called smart-beta ETF. Smart-beta refers to the less-traditional methods that may be used to form an index—methods that investors buying these ETFs hope will prove “smarter” over time (through outperformance) than traditional, market-cap weighted indexes.
The argument goes as follows: owning a traditional ETF that tracks the S&P 500 may not provide investors with as much broad diversification as they think they are getting because the largest components within the index have substantially more weighting than the smaller holdings. So the S&P 500 may function more like the S&P 50 with a sprinkling of 450 other companies. Market-cap weighted indexes strongly favor stocks that have strong recent performance and are currently popular among investors, regardless of the underlying valuation. While this does accurately reflect what is going on in the market, some research argues that it ignores some of the valuation criteria that may be important for long-term investing success and, perhaps, best performance results.
The solutions? One ETF provider created an S&P 500 product that gives equal weight to all 500 stocks within the index. If you chart this ETF out against a standard S&P 500 tracking investment, they are running fairly similar performance results, with the equal weight index inching out the traditional S&P 500 by about 0.5% over the past year. Another ETF provider created a low-volatility product that owns the 100 stocks within the S&P 500 that have experienced the least volatility over the trailing 12 months. That ETF is also outperforming the S&P 500 over the past 12 months, although the performance trails if you chart it out over longer periods of time.
Other smart-beta ideas include the creation of indexes based on earnings, cash-flow, book value, and dividends. While it makes logical sense that an investor may prefer to buy an ETF based on something other than market-cap weighting, it can be viewed as swinging the ETF product back towards the realm of active management—a category that ETFs were designed to avoid. Some assert that these new products actually bridge the gap between active and passive management and provide a good option for investors. The debate continues because many of these products haven't been around long enough to properly assess their performance. Some of these newer ETF products also come with higher expense ratios, another debatable direction to take a product praised for its typically ultra-low operating expenses.
Another side of the ETF market that has been gaining traction is fixed-income. In order for an ETF to function properly, there must be a sufficient level of liquidity in the underlying holdings of the index. This presents some challenges in parts of the bond market where transparency and liquidity aren't as readily available as they are in most equity markets. However, a combination of improved fixed-income trading systems, along with a growing demand for ETFs, has led several product sponsors to roll out more fixed-income ETFs.
We’ve also seen continued popularity of ETF products that offer currency hedging. These products aim to strip out currency volatility that can dramatically reduce (or enhance) returns within a globally diversified portfolio. For example, Europe and Japan both returned positive numbers to investors during 2014, on the basis of their local currencies. However, they both returned negative performance when that performance was converted to U.S. dollars. ETF providers are now offering a way to hedge currencies so that concerned investors can focus on the fundamentals of the companies in which they are investing.
Investing Within a Diversified Portfolio
The primary goal for many investors remains creating a broadly diversified portfolio that can withstand market volatility over the long term. Designing a portfolio with only new and experimental ETF products is a risky strategy. However, choosing to incorporate a few ETFs based on criteria other than market-cap weighting, and perhaps hedging out currency risk, could provide interesting options for your portfolio.
 RSP vs. SPY as of 4/10/2015
 SPLV vs SPY as of 3/31/2015: SPLV outperformed SPY by 1.85% in the 12-month period ended 3/31/2015. Over a 3-year period, SPY has outperformed SPLV by 1.35%
 MSCI EAFE Index +5.7% hedged to USD in 2014 vs. -4.9% unhedged. MSCI Japan Index returned 8.5% hedged to USD vs. -4.0% unhedged.