COLUMN-Smart-beta stock ETFs focus on fundamentals


By John Wasik

CHICAGO, Nov 12 (Reuters) - Holding stocks in a passiveindex fund as a core portfolio holding has generally been arock-solid idea. You can own nearly the entire market at a lowcost and not get snagged in market timing errors.

Yet most index funds are capitalization-weighted, meaningthey hold the most popular stocks by market value. That couldlead to owning the most overpriced stocks, which may incur moredownside risk when the market heads south.

A better alternative could be to own "smart-beta" funds.While still built on indexes, the stocks within these basketsare often picked for their cash flow, book value, dividends andsales. That means instead of picking all of the potentiallyover-valued stocks that have won the market's latest beautycontest, more fundamental measures are applied.

Generally, smart-beta funds emphasize large stocks withhealthy dividends that may not be everyone's favorite at themoment. Their portfolios may include a healthy dose of older,defensive and dividend-rich companies in manufacturing,utilities, healthcare and financial services.

The strategy behind smart-beta funds also leans towardfundamental indexing that relies on identifying themost-consistent companies year after year in terms of top-linesales growth and cash flow.

One such fund, the PowerShares FTSE RAFI US 1000 Index ETF, tracks an index of 1,000 stocks chosen for suchfundamentals. It includes name brands like ExxonMobil Corp., Bank of America Corp. and General Electric Co.

These old-line firms are not exactly high-tech or IPOdarlings that dominate the news, but they do have steady cashflow and dividends. Their prices might hold up better in adownturn.

The RAFI fund, which charges 0.39 percent for annualexpenses, has one other distinction: In a year that has favoredmega-caps, it has outperformed the S&P 500 Index. The fund is upmore than 35 percent for the year through Nov. 8, compared with31 percent for the S&P Index.

While this has generally been a good year for big U.S.stocks, the longer-term outperformance of the RAFI fund is stillrobust. Its annualized return exceeds 20 percent over the pastfive years, compared with 16 percent for the S&P Index.

Although there's no guarantee that the fundamental approachor smart-beta advantage will hold up over longer periods oftime, it's worthwhile noting that not all smart-beta funds do aswell.

The PowerShares S&P 500 Low Volatility ETF employsa slightly different strategy than the RAFI fund. It's up 23percent, compared with the S&P's 31 percent over the annualperiod through Nov. 8. The fund charges 0.25 percent annually.

Keep in mind that smart-beta funds are more expensive thanstandard S&P index funds and may not always hold an edge.

For a basic cap-weighted index fund like the SPDR S&P 500 fund, for example, you'd pay 0.09 percent annually.That's less than a quarter of the cost of the RAFI fund.

The theory that a fundamental or low-volatility fund mightshield you from stock-market risk may not be entirely valid,either.

The RAFI fund lost nearly 40 percent of its value in 2008,compared with 37 percent for the S&P 500. Its five-year standarddeviation, a volatility measure, is nearly 20, compared with 16for the S&P 500.


Will these returns continue? Although nothing fundamentallyhas changed in the economy of late - there's still a sluggishrecovery in place - you'll still need to keep an eye on FederalReserve policy.

If the Fed maintains its stimulus, it will continue to favorstocks, particularly large companies. Should it pull back thereins of its bond-buying program, stocks could retreat.Corporate earnings also need to stay on an upward course.

"If equities are going to sustain a move to the upside,"writes Bob Doll, chief equity strategist for Nuveen Investmentsin his weekly newsletter, "we believe earnings must assume aleading role. More specifically, earnings and revenues need toadvance, given that profit margins are pushing the bounds ofsustainability."

As a way to buy and hold stocks, though, smart-beta fundsmay be a good vehicle for those who need long-term stockexposure. These portfolios represent some of the most durablecompanies in the world - and they pay steady dividends. Whilethere is no perfect way to capture the upward momentum ofgrowing dividends and profits, smart-beta funds may prove to bea reliable core holding.

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