A lot of ink has been spilled about two ETFs targeting Japan that have rallied twice as much as the recent rally in Japanese equities.
These two Japan ETFs aren't alone either. Renewable energy, as represented by the Thomson Reuters Global Renewable Energy Index, has returned nearly 32 percent over the past year, but two alternative energy ETFs managed to beat that benchmark by more than 20 percentage points.
I'll look at these and other funds that have demonstrated significant alpha over the past year and, as we'll see, their roads to alpha are paved quite differently.
So, let's start with Japan, with the MSCI Japan Investable Markets index, which has appreciated 22 percent over the past year.
IndexUniverse's benchmark for the Japanese market and these two ETFs all aspire to broad exposure to Japanese equities, but there's huge disparity in their returns. So what gives?
While Japanese equity markets were rallying, the yen was collapsing as policymakers threatened to and actually launched fresh measures of quantitative easing:Returns of ETFs that don't neutralize currency crosses were getting hurt.
However, because DXJ's and DBJP's portfolios are currency-hedged, returns weren't dragged down by the falling yen. In fact, the latest rally in Japanese equities clearly brought currency-hedged ETFs fully into the limelight.
Currency hedging makes sense, especially for countries with big export markets. The domestic economy tends to improve as the currency weakens because exports become less expensive and more appealing in the global market.
Returning to DXJ and DBJP, the remaining return difference between the two ETFs is primarily attributable to sector allocations.
DXJ underweights financials—which happened to be one of the best-performing sectors over the past year—in favor of other sectors.
Currency hedging is only one of the ways that some ETFs have picked up alpha over the past year. Several sector-based ETFs earned alpha by reducing their exposure to the biggest names in their sector—instead favoring companies lower on the size spectrum.
Take U.S. technology for example, where the Guggenheim S'P Equal Weight Technology ETF (RYT) and the PowerShares S'P SmallCap Information Technology ETF (PSCT) have each returned about 27 percent over the past year when the U.S. tech sector only returned 9 percent.
In this case, reducing or eliminating the effect on the portfolio of the biggest names in the sector proved beneficial. In particular, both funds benefited from having less Apple Inc. (AAPL), which has fallen 32 percent over the past year.
Moving forward, however, there's no reason to presume that reducing the effect of large-cap tech companies will prove a fruitful strategy.
AAPL's size, combined with its atrocious price performance over the past year, seriously hampered the performance of many U.S. technology ETFs. But large single-name exposure is a two-way street.
Among eight alternative energy ETFs, two earned more than 30 percentage points of performance alpha—largely on the back of a couple big names.
The Tesla Effect
The Market Vectors Global Alternative Energy ETF (GEX) and the First Trust Nasdaq Clean Edge Green Energy ETF (QCLN) have each returned more than 50 percent over the past year and, in the process, earned more than 30 percent alpha relative to the broad "global renewable energy" market.
The outperformance is largely attributable to excess exposure to a few strong-performing stocks.
In particular, each fund has hefty exposure to Tesla—which is up more than 250 percent over the past year. Strong performers CREE (CREE) and solar power generator SunEdison (SUNE) (up 300 percent) also had sizable effects on each portfolio, given their respective returns of 150 percent-plus and 300 percent. In the end, extra exposure to these companies helped GEX and QCLN exhibit impressive alpha relative to their broad market.
Other funds earned alpha that can be attributed to their nuanced strategies, as opposed to single-name exposure.
For example, the PowerShares KBW Premium Yield Equity REIT (KBWY) earned alpha in excess of 17 percent over the broad U.S. real estate market because its refined strategy nixes cap weighting in favor of a dividend-focused strategy.
The strategy is particularly relevant to the world of real estate investing, where dividend yield is often what brings investors to the table in the first place.
Other ETFs managed to earn serious alpha by implementing quant-driven strategies.
As a broad market, emerging market small-caps have returned about 11 percent over the past year. but the First Trust Emerging Markets Small Cap AlphaDex ETF (FEMS) managed to return more than 30 percent. The secret behind its success is a quant-driven strategy that ranks and weights a small basket of stocks based on a variety of growth and value factors.
Although the AlphaDex strategy led FEMS to outperformance, the strategy's success is less proven across the broad swath of nearly 40 First Trust ETFs that use some variation of the strategy.
Looking at the big picture, several ETFs have hugely outperformed their broad market by employing a range of tactics and strategies ranging from currency hedging, nuanced weighting strategies, quant-driven factor strategies, or simply by shuffling big-name exposure.
While each strategy has proved successful over the past year, they ought to be evaluated on an individual basis for applicability and relevance moving forward.
At the time this article was written, the author held no positions in the securities mentioned. Contact Spencer Bogart at email@example.com or follow him on twitter @Milton_VonMises.
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