Exchange-traded funds have come a long way since the granddaddy of them all, the SPDR S&P 500 ETF (NYSE:SPY), was launched in 1993. Now, about 1,300 ETFs exist, covering almost every imaginable market niche from stocks and bonds (domestic and foreign, long and short) to currencies, commodities and even super-obscure investments like volatility indices and yield curves.
Much of the profusion is unnecessary, and I expect hundreds of these funds to bite the dust during Wall Street’s next major bear market. Still, here and there, a great new idea pokes through that has the potential to become a long-term winner.
One type of fund I believe will prosper in the years ahead is the so-called “intelligent” ETF. From the beginning, most ETFs have simply mimicked a more or less static, capitalization-weighted index like the S&P. “Capitalization-weighted” means the stocks with the biggest market value carry the heaviest weight.
As a result, index funds like SPY automatically get stuffed with the most overvalued stocks in the market. When the bubble bursts — as the tech craze did from 2000 to 2002 — investors who own a cap-weighted fund take massive losses.
Intelligent indexing works to head off such disasters by following objective rules — based on investment merit — to select stocks. Notice I said rules. Stock picking isn’t left to a portfolio manager’s discretion, nor are portfolio weightings. With an intelligent ETF, you don’t have a Bill Miller or a Bruce Berkowitz going off the deep end with extreme bets that can cripple the fund’s performance.
Furthermore, the intelligent ETFs I favor adhere to value-oriented rules, which automatically steer the fund away from fad stocks. If you’re looking for a fund you can keep for a lifetime, then pass along to your spouse or heirs when you’re gone, an intelligent ETF with a value tilt might be the way to go.
Here are three intelligent ETFs to slip into your own portfolio:
PowerShares S&P 500 Low-Volatility Portfolio
The PowerShares S&P 500 Low-Volatility Portfolio (NYSE:SPLV) is my top-priority buy. This fund owns the 100 stocks in the S&P with the lowest volatility (smallest price swings) as measured during the past 12 months. Quarterly rebalancing nips problem stocks in the bud and tosses them out.
For every $1,000 you invest, SPLV will generate 70% more income than a 10-year Treasury note — and that’s before any dividend increases almost certainly coming down the pike.
PowerShares Buyback Achievers Fund
The PowerShares Buyback Achievers Fund (NYSE:PKW) is based on a principle well-known to veteran market observers: Companies that consistently buy back large amounts of their own stock tend to be rewarded with a share price that outperforms the market averages. PKW owns 139 firms, all of which have repurchased at least 5% of their outstanding stock in the past 12 months.
Does the strategy work? Well, PKW has beaten the S&P in three of the past four full calendar years of the fund’s existence and ran about 800 basis points ahead of the index in 2011. What’s more, the fund lost significantly less than the S&P during both the 2008 debacle and the April-October 2011 plunge.
With a slender dividend yield of just 0.77%, Buyback Achievers is a “growthier” vehicle than SPLV. Choose PKW if you don’t need current income and can afford to hold the fund at least three to five years to capture a full helping of capital gains.
JPMorgan U.S. Dollar Emerging Markets Bond Fund
The JPMorgan U.S. Dollar Emerging Markets Bond Fund (NYSE:EMB) is my one selection in the bond area. As you know, if you’ve been reading my stuff a while, I’m a fan of emerging-markets bonds. Why go with this ETF, as opposed to an open-end mutual fund or a closed-end fund? Because the manager’s discretion is strictly limited. Under the rules of EMB’s investment policy, the fund limits the weights of countries with higher debt outstanding and reallocates excess cash to countries with lower debt outstanding.
This “safety valve” protects you against the tendency of an enthusiastic portfolio manager to load up on a risky country’s bonds because they pay a higher yield. Granted, EMB yields less (4.97%) than some competitors. But the fund is efficiently managed, with a 0.6% annual expense ratio — and you can rest easy over the long haul with Morgan’s emphasis on capital preservation.