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This New Class Of 'Smart' Funds Promises Solid Gains In 2014


Thanks to a popular financial website, the term "alpha" has become popular over the past few years. Yet the ETF industry wants you to think a lot more about "beta." 

Dozens of new exchange-traded funds were launched in 2013 in an emerging category known as "smart beta," and investors will be treated to many more of these ETFs in the coming year. It's a welcome development for an industry that risked growing stale.

While the term "alpha" refers to any gains an investor can reap above the broader market, beta refers to how a stock or fund should be expected to perform relative to a given benchmark.

In recent years, investors have had plenty of options among ETFs that can be expected to trade in a predictable fashion. From S&P 500 index funds to technology funds to high-yield bond funds, these passively managed ETFs are a great way to provide predictable exposure at a very low cost.

These ETFs have emerged as great values, especially in relation to higher-cost actively managed mutual funds, which can carry expense ratios exceeding 2%.

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Now, this new class of smart-beta ETFs -- which also go by terms such as fundamental ETFs, enhanced indexing ETFs or strategic beta ETFs -- aims to split the difference. These funds tend to adjust their portfolios with much more frequency than passively managed funds, promising nimbler performance in changing market conditions, and though they cost more than their passive rivals, their expense ratios rarely exceed 0.75%. 

There are now more than 150 of these actively managed ETFs available, and dozens more are being lined up for launch in 2014. As a result, you'll want to track ETF industry developments to see where this dynamic category is headed.

  Smart-beta ETFs have emerged as great values, especially in relation to higher-cost actively managed mutual funds, which can carry expense ratios exceeding 2%.  

How Smart-Beta ETFs Work
These funds often seek to replicate strategies used by hedge fund managers to gain a market edge. For example, Global X Top Guru Holdings Index ETF (NYSE: GURU), which was recently profiled by my colleague David Goodboy, holds stocks that are in favor with leading fund managers. Unlike passive ETFs, this ETF continually changes its asset mix. The 0.75% expense ratio is a bit higher than most ETFs, but this fund's 40% gain in 2013 beat the benchmark S&P 500 Index by a full 10 percentage points.

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There are a variety of these smart-beta ETFs, including funds that focus on general fundamental approaches, such as low price-to-earnings ratios (P/Es) or high-growth stocks; risk/volatility funds; contango/backwardation (that is, ETFs that focus on the rollover of short-term contracts); long-short spread funds; and funds focused on technical analysis.

Another example of how this approach works: the PowerShares FTSE RAFI 1000 ETF (NYSE: PRF), which owns the most attractive large-cap stocks based on measures such as low price-to-book value, strong cash flow, and solid dividends, has risen 22.4% on average over the past five years, according to Morningstar, roughly 4 percentage points better than the S&P 500. 

This fund doesn't simply buy and hold but instead responds to price movements in various stocks. "This contra-trading approach (buying on weakness and selling on strength) helps the fund more immediately profit from market mispricing," note analysts at Morningstar, which gives this fund five stars. 

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The First Trust Capital Strength ETF (Nasdaq: FTCS) is one of my favorite smart-beta ETFs, as its approach dovetails with several financial metrics that I favor. The fund owns companies with at least $1 billion in cash and short-term investments that also have returns on equity exceeding 15%. These kinds of stocks tend to deliver solid gains (as evidenced by this fund's 2-percentage-point annualized gain over the S&P 500 over the past five years) and also tend to have less volatility. 

Over the past year, my colleague Michael J. Carr has discussed his preference for using Relative Strength (RS) to find winning investment ideas. If you're a fan of this momentum style of investing, you can also check out the PowerShares DWA Momentum Portfolio ETF (NYSE: PDP), a smart-beta fund that focuses mostly on mid-cap stocks showing impressive price action. 

Risks to Consider: Many of these ETFs have outperformed their benchmarks in recent years, but they may not be able to do so if the market heads lower in 2014.

Action to Take --> If you have a favorite investment angle but found traditional ETFs to be ill-suited to that approach, the emerging class of actively-managed smart-beta ETFs is worth exploring. If there isn't yet a fund in place that fits your approach, chances are there will be in 2014.

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