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4 ETFs that could beat the market

Here are four ETFs that may outperform the market over the long run.

  • By Daren Fonda,
  • Fidelity Interactive Content Services
  • – 08/07/2013
  • Investing in ETFs
  • Exchange-Traded Funds
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Imagine you have $100,000 to invest and at least two decades before you need the money.

Many financial advisers would recommend putting the money in stocks, which have returned roughly 10% a year on average since 1926, according to research from Ibbotson Associates.

So where would you put the cash?

You might invest some of it in an actively managed fund with a solid, long-term track record and management team.

Another option would be a passive index fund like the SPDR S&P 500 ETF (SPY). These funds, which typically use stock market value as a basis for fund construction, are considered standard market proxies and are very low-cost; typical fees are $10 on a $10,000 investment annually, or even less.

Yet there's a third way to go: index ETFs based on stock "factors" other than stock market value.

To capitalize or not to capitalize?

In traditional indexes like the S&P 500 (.SPX), companies with the largest market value receive the most weight. Apple (AAPL), for example, accounts for about 3% of the S&P 500, since at roughly $415 billion its stock is worth more than any other U.S public company (though Exxon Mobil (XOM) is a close second). Overall, the index's top 10 companies make up around 18.5% of its value, according to S&P, and for better or worse, these stocks heavily impact its returns.

Yet some studies suggest that market cap-weighted indexes aren't always the best performers. Value stocks may outperform growth, for example, and there are periods when stocks exhibiting the most share price momentum or lowest volatility fare best.

Indexes tilted to these "factors," in fact, seem to fare better over several decades, according to a 2013 study by index provider MSCI.

Commissioned by the Norwegian Ministry of Finance, the study analyzed global stock returns from December 1992 to September 2012. The authors used the MSCI World Index — a cap-weighted index of some 1,600 stocks — as their benchmark. They tracked its returns against indexes tilted to other factors: low volatility, low valuation, share price momentum and low market cap.

The upshot: While the MSCI World returned an average 7.2% a year, the other indexes returned 8.1% on average. Value stocks (with below average price-to-earnings and price-to-book ratios) led the pack with an 8.4% annualized return. In addition, none of the alternative indexes were much more volatile than MSCI World Index, according to the study, indicating market risks were similar across the board.

"Over the long run we found that the alternative-weighted indexes outperform," says Jennifer Bender, vice president of index research with MSCI and a co-author of the study.

The alternative indexes may offer diversification benefits as well, Bender says. Momentum and value indexes have a low correlation with each other, meaning they don't move closely in tandem. And using them together can help smooth out returns, since one may fare well while the other slumps.

Granted, the study didn't account for transaction costs or management fees; ETFs are not index replicas and returns may deviate quite a bit, something known as "tracking error;" and MSCI used simulated indexes in its study, which aren't available to the public.

Each index also went through long stretches of underperforming. While the value and low-market-cap indexes emerged on top, they both trailed the MSCI World over long stretches. And the value, momentum and low-volatility indexes captured most of their "excess returns" between 1992 and 2002, faring only slightly better later on.

4 unconventional ETFs

With investing styles going in and out of fashion, one strategy would be to spread your bets. Many large pension funds, for example, stick with cap-weighted index funds for half their stock exposure, says Bender. For the other half of their stock portfolio — where they're aiming to beat the market — they may use a mix of actively managed funds and strategies that track alternative indexes, she says.

Here are four "factor" ETFs to consider, based on interviews with industry experts and our research. Remember: ETFs can be volatile and involve currency and other risks. These ETFs may lag the market for long stretches, and could lose money in market declines.

Also keep in mind that these ETFs hold overlapping stocks, which may increase your exposure to some stocks or sectors more than you had intended. As always, you should do your own research or consult an adviser before investing.

iShares MSCI USA Minimum Volatility ETF

  • Ticker: USMV
  • Expense ratio: 0.15%
  • Dividend yield: 2.8%

Low-volatility stocks "tend to be big, boring and dividend-paying," says Morningstar analyst Samuel Lee. Those characteristics add stability to a stock — and help make the iShares MSCI USA Minimum Volatility ETF about a third less volatile than the broad market, according to Morningstar.

In fact, most of the ETF's 134 holdings are giant companies with stable earnings such as drug maker Bristol Myers Squibb (BMY), PepsiCo (PEP) and Wal-Mart Stores (WMT), the nation's biggest retailer.

The downside: The ETF is defensively postured with about a third of its assets in consumer staples and health care stocks. It has minimal exposure to cyclical sectors such as energy and materials, which may be a headwind during strong market rallies.

iShares MSCI EAFE Value ETF

  • Ticker: EFV
  • Expense ratio: 0.40%
  • Dividend yield: 4%

The iShares MSCI EAFE Value ETF tracks a global index of large-cap stocks that have a few common characteristics: low price-to-book ratios, below-average P/E ratios and slower growth rates than the broader market.

Value stocks have "historically outperformed their growth counterparts in nearly every market studied over long horizons," according to Morningstar analyst Alex Bryan. This ETF aims to capture that "value premium."

The downside: Value stocks can stay out of favor for years and dividends paid by these companies may be susceptible to cuts. Financials stocks — many of them European banks — make up 36% of the ETF. The ETF's foreign stocks pose currency as well as foreign market risk.

iShares MSCI USA Momentum Factor ETF

  • Ticker: MTUM
  • Expense ratio: 0.15%
  • Dividend yield: 1.7%

Winners keep winning and losers keep losing. In essence, that's the theory behind momentum investing. Studies since the 1960s indicate the "momentum effect" can lead to outperformance versus the traditional market, according to MSCI.

The iShares MSCI USA Momentum Factor ETF invests along those lines, holding 123 large- and mid-size stocks with strong price momentum over trailing 6- and 12-month periods. Top holdings are familiar names such as Johnson & Johnson (JNJ), Pfizer (PFE) and Procter & Gamble (PG).

The downside: The ETF has a short track record, launching in April 2013. Health care stocks account for about 30% of its assets, nearly three times the weighting in the S&P 500. Stocks may lose their momentum at any point and the ETF could be more volatile than the market as a whole.

SPDR S&P International Small Cap ETF

  • Ticker: GWX
  • Expense ratio: 0.59%
  • Dividend yield: 1.6%

Small-cap stocks can be highly volatile and foreign stocks add other risks. Yet those risks should translate to higher returns over time, according to Morningstar analyst Abby Woodham, who suggests the SPDR S&P International Small Cap ETF for investors with a long horizon and "high risk tolerance."

Holding around 840 stocks with an average market cap of $1.5 billion, the ETF is broadly diversified. Its largest holding — Swiss industrial firm Belimo — accounts for just 0.64% of assets. Foreign small caps also look cheaper than U.S. small caps, notes Woodham, making the ETF's valuation "particularly attractive."

The downside: Around a third of the ETF is concentrated in Japan, a market that has soared over the last year and may not have much upside potential in the near-term. This ETF's expense ratio is relatively high, according to Morningstar, and the ETF may outperform or lag its benchmark index due to high tracking error.


Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.

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