[Editor's Note: We are rerunning some of our best stories of the year. This article appears in our November 2016 issue of ETF Report.]
Some of this year's most innovative exchange-traded funds are ones that look at gender diversity as a way to boost corporate performance, generic drugs and even using crowdsourcing to make bets on which stocks will outperform from month to month.
ETF innovation right now is falling into two camps—one's creating thematic ETFs and the other's using smart beta, says Dave Nadig, director of ETFs at FactSet. Although thematic investing itself isn't anything new, fund construction is different than it has been in the past.
With more data available, these funds have greater focus, so their return patterns can provide a source of diversification.
"That doesn't mean it will go up," he noted.
The smart-beta ETFs have been pretty successful, but Nadig also says it's starting to become less innovative because there are so many out there now. So more and more ETF innovation is being found in thematic investment themes.
There's still room for unique products, such as ones that look at a different product structure. But innovation doesn't equal success, as the creators of the CrowdInvest Wisdom ETF (WIZE) found. The fund revolved around users voting on what stocks to include in the index by casting their bearish or bullish views on the CrowdInvest IOS mobile app, but the fund only lasted five months before closing in late September.
WIZE isn't the first unique ETF to close quickly. Nadig notes that two of the most innovative ETFs he saw in a long time—the AccuShares Spot CBOE VIX Up Shares fund (VXUP), which tracked the CBOE Volatility Index; and the inverse fund, VXDN—also closed in September due to lack of buyers.
"Finding that next great idea is particularly difficult. Even the folks at PureFunds would tell you that HACK (the PureFunds ISE Cyber Security ETF) caught on more than expected," he said. "Part of it's being in the right place at the right time with a solid product design. Certainly there's some science to it, but there's some luck."
Following are new ETFs that launched this year that the editors and writers at ETF Report deemed to be the most innovative.
SPDR SSGA Gender Diversity Index ETF
In the growing socially responsible fund world, SHE is the only ETF that exclusively focuses on increasing women's participation in corporate America's senior leadership.
Using the concept that companies with strong female leadership have higher returns than companies whose leadership and boards comprise mostly men, State Street created the SSGA Gender Diversity Index. It looks at the largest 1,000 U.S. companies for senior-leadership gender diversity, within their sector. Companies in the highest 10% in each sector are included, and the firms must have at least one woman on its board or as chief executive officer.
SSGA said the idea behind the index came from the California State Teachers' Retirement System's efforts on increasing the number of women in leadership positions in corporate America.
Including more women helps the bottom line, SSGA says, citing a 2015 MSCI study noting companies with strong female leadership had a 36.4% higher return on equity versus companies without a critical mass of women at the top.
MSCI defined strong female leadership as having a board of directors with at least three women or a higher percentage of women than the average in the company's country. State Street notes that MSCI's methodology for the study is different than the index's methodology, so investors shouldn't try to correlate the study's results with returns.
SSGA believes investments in companies with gender-diverse leadership may influence corporate America, and when launching the ETF, SSGA said it will direct a portion of its revenue to nonprofit organizations that help develop girls as leaders in business and science.
As of June 30, SHE's top individual holdings were Berkshire Hathaway (Class B) at 6.5%, Home Depot at 6.3% and Oracle at 4.9%. The top sectors were industrials, at 20.4% and health care, at 20%. The index is market-cap-weighted.
iShares MSCI Global Impact ETF
Another fund that focuses on environmental, social and governance (ESG) factors, MPCT was launched on Earth Day this year, with the ETF focusing on the companies that seek positive change, particularly on the environmental and social aspects of ESG.
To stand out in the growing ESG field, MPCT seeks to not only focus on a company's ESG performance, but to measure the impact of its work. The ETF is designed to track the newly created MSCI ACWI Sustainable Impact Index. Using the United Nations' Sustainable Development Goals as a guide, this index focuses on companies that get a majority of their revenue from products and services that address the environment and social challenges defined by the UN. Among some of those goals are energy efficiency, sustainable water, sanitation, nutrition and education.
MPCT holds true to firmly held ESG beliefs and avoids firms that have more than 10% of their sales from alcohol or tobacco, or that are involved in predatory lending.
This new MSCI ACWI Sustainable Impact Index has greater exposure to companies seeking to make a positive impact versus the MSCI ACWI Index, BlackRock says. Citing data from MSCI, the new index had 71% higher revenue exposure to sustainable impact solutions than companies in the MSCI ACWI Index in fiscal year 2014, particularly when looking at companies that provide basic needs, and those focused on mitigating climate change.
As a global fund, 40% of its holdings are in the U.S., about 30% in Europe and the rest in Asia. Industrials are its top sector, at 28%, and it's rebalanced annually.
3D Printing ETF
PRNT is the first ETF that seeks to capture the companies that focus on 3D printing, also known as additive manufacturing, which makes three-dimensional solid objects from a digital file.
There's a lot of excitement around 3D printing and the potential it has to disrupt manufacturing. ARK cites a McKinsey report forecasting the 3D printing market to grow from $4 billion in 2014 to between $180 billion and $490 billion by 2025. This fund debuted two years after 3D stocks saw a boom-and-bust cycle in 2014, with many of the smaller names now trading at a fraction of their 2014 highs, such as 3D Systems, Stratasys and Voxeljet.
The ETF is based on the Total 3D-Printing Index from Solactive AG, which tracks price movements of stocks of companies involved in the 3D printing industry. Because there are only a handful of publicly traded companies that are purely in 3D printing, the index also includes related businesses.
ARK calls this a multifactor-weighted ETF, with equal weighting within each business sector. Three-D printing hardware has a 50% weighting, computer-aided design and 3D printing simulation software have a 30% weighting, 3D printing centers have a 13% weighting, while scanning and measurement is weighted at 5%, and at 2% is 3D printing materials.
Not surprisingly, the fund is heavily weighted in the information technology sector, at 53%. U.S. companies dominate the fund, at 69%, with European and Taiwan names making up the rest. The fund holds equities and depositary receipts of exchange-listed companies, and many of the names are small-cap firms.
Global X Millennials Thematic ETF
MILN was the first ETF that looked to invest in firms that might benefit from the habits of U.S. millennials, a group of people born between 1980 and 2000, who are the largest living generation. A thematic ETF, the concept behind this fund posits because of millennials' sheer numbers, they can drive the business outcomes of certain companies based on their preferences, which are different from prior generations. Unsurprisingly, companies are eager to tap into that spending power.
MILN is based on the Indxx Millennials Thematic Index and has a broad focus of categories that may be of interest to millennials, including social media, entertainment, dining, apparel, health, travel, education, housing and financial services. While several of those categories are of interest to anyone, not just millennials, the idea of the fund is to zero in on that generation's supposed interest in eating out often, ordering online versus buying in stores and a focus on choosing healthier products.
The idea behind the ETF is that, as this generation ages—with the youngest being about 16—it can shape which companies outperform as millennials start to increase their earning power.
This isn't the only fund that focuses on millennials, as the Principal Millennials Index ETF (GENY) debuted in mid-August. But what makes MILN different is its focus solely on the U.S., whereas GENY includes some international companies.
Many of the firms MILN holds are well-known internet names, and most of the top 10 holdings are companies not much older than many millennials, with LinkedIn, Amazon, eBay and Facebook rounding out the top four. But what makes it more than just a technology fund is that just over 50% of the fund's weight is in consumer cyclicals, with technology at 31%.
Summit Water Infrastructure Multifactor ETF
Investing in water isn't a new idea. After all, there are four global water ETFs already trading, with the PowerShares Water Resources Portfolio ETF (PHO) being the oldest and largest.
What makes WTRX stand out is that it takes a smart-beta approach to its investment theme, whereas the other four water ETFs are mostly cap-weighted funds. The ETF is based on the Summit Zacks Global Water Index, which tracks the performance of about 30-50 publicly listed U.S. and international companies dedicated to the global water industry.
WTRX's index uses a proprietary methodology based on fundamentals to evaluate and select water companies. The index selects companies based on their yield and risk/return profile and is rebalanced quarterly. Geography also plays a role, and while it seeks to be globally diversified, it gives a greater importance to yield and the risk/return profile.
The fund divides its holdings into two groups—water utilities and water industrials—and applies a three-factor model to each. For water utilities, the fund focuses on enterprise value/EBITDA, price-to-earnings ratio and return on equity. Water industrials include water utility line construction, implement/irrigation equipment, water purification and treatment chemicals. The three factors for this group are P/E ratios, gross margin and return on invested capital.
Based on those factors, the top 50% are selected. Overall, 35% of the portfolio's total weight goes to the utilities segment and 65% to the industrials segment, with individual position weights determined by dividend yield.
VanEck Market Vectors Generic Drugs ETF
Health care ETFs are popular, and within this sector, there are about six ETFs that focus on pharmaceuticals, but GNRX stands out for being the only one that focuses on generic drug manufacturers.
With a push to lower health care costs, and more people around the world taking some sort of prescription drug, GNRX expects this segment of the pharmaceutical industry to grow as people seek out lower-cost drugs as an alternative to pricey name brands. There are 80 different holdings in GNRX, versus the 25 in the VanEck Vectors Pharmaceutical ETF (PPH), which gives it more diversity.
Most pharmaceutical funds are focused on developed markets, where people can still pay for name-brand drugs, but GNRX has exposure to emerging markets, where consumers can more easily afford generic drugs. IMS Health says, as a percentage of drugs distributed globally, spending on generics is expected to increase to 46% in 2018 from 40% in 2013, with emerging markets likely to make up much of that growth.
The ETF is based on the Indxx Global Generics & New Pharma Index, which tracks companies that receive—or could receive—a major portion of their revenues from the generic drug industry, or that have a primary business focus on the generic drug industry.
With the focus on generic drugs versus name brands, GNRX could benefit from the rise of biosimilar drugs. These are biologic medical products that are approved by the U.S. Food and Drug Administration based on showing they are highly similar to another FDA-approved product, have no meaningful difference in terms of safety and effectiveness, and can be made when the original product patent expires.
CrowdInvest Wisdom ETF
The idea that groups can be smarter than the smartest people in them was the basis for WIZE, which was the only crowd-sentiment-weighted ETF. Unfortunately, investors didn't crowd to this fund, and it closed on Sept. 27 of this year.
CrowdInvest said WIZE was a smart-beta alternative to the broad-based market index ETFs. The ETF was based on the CrowdInvest Wisdom Index, which comprised U.S.-listed stocks weighted by crowd sentiment. Users voted on what stocks to include in the index, by casting their bearish or bullish views on the CrowdInvest IOS mobile app. Stocks were also weighted by users' sentiment.
The methodology included all U.S.-listed stocks with an average daily volume of more than $15 million over the preceding 20 days. The top 35 stocks included in the index would be ranked in order of percentage of net long votes, and weightings for each of the constituents were based on their ranking in the monthly vote. Minimum rankings were 1% and the maximum was 4.9%.
If not enough users participated in the poll, the index would choose the top 35 eligible stocks by market cap and would equal-weight the portfolio.
The index would rebalance monthly, and the index provider would rebalance each holding in accordance to the results of the monthly vote. Up to four holdings could be replaced, based on a set of predetermined rules.
At the time of closing, the fund's top sectors were consumer cyclical, at 24%; and technology, at 21%. The top five holdings—all at 4.90%—were AGN, HRB MS, Oracle and VFC.
Sprott Buzz Social Media Insights ETF
How much do you trust strangers on the internet? Enough for them to pick your portfolio? BUZ does just that, selecting stocks for its underlying exposure based on what people say about them online.
To build its index, BUZ uses proprietary algorithms to cull a variety of social media platforms for the most-mentioned U.S. stocks. Twitter, Facebook, LinkedIn, Reddit and YouTube are among the sites searched, as well as finance websites such as Seeking Alpha, Investopedia and Motley Fool. Even traditional media outlets, like the Wall Street Journal and Bloomberg, are examined.
The software then measures whether the chatter about these companies is positive, negative or neutral. Opinions are given greater or lesser weight depending on how much influence the people discussing the companies have within their communities, and how accurate they've been historically.
The 75 stocks with the most positive sentiment scores are selected for inclusion, and weighted using opaque scoring. To tamp down risk, BUZ only considers firms with an average daily trading volume of $1 million or higher, and a market cap of at least $5 billion. That excludes all small-caps and many midcaps.
Since its index rebalances monthly, BUZ's holdings can vary widely month to month. Tech stocks—such as Twitter, Facebook, Microsoft and Alphabet—have historically dominated top holdings; unsurprisingly, the internet likes to talk about internet-related stocks.
Crowd-sourced stock ETFs are nothing new. For example, the now-closed CrowdInvest Wisdom ETF (WIZE) let users of a proprietary social platform vote on which stocks to hold. Direxion's All Cap Insider Sentiment Shares ETF (KNOW) and Guggenheim's Insider Sentiment ETF (NFO) both select stocks based on what company insiders buy. Even the Global X Guru Index ETF (GURU) and AlphaClone Alternative Alpha ETF (ALFA), which track stocks owned by leading hedge funds, use the same follow-the-crowd idea. What sets BUZ apart is the breadth of social media sources that it searches, as well as the computer algorithms it uses to search.
WisdomTree Fundamental U.S. High Yield Corporate Bond Fund
"Junk" bonds might promise higher yields, but with them comes higher risk of financial distress—even default. Face it: Many of these companies didn't earn the label "junk" for nothing.
WisdomTree, however, offers a new smart-beta twist on the high-yield space, with a "screen and tilt" ETF that it says excises troubled companies, leaving only the good.
WFHY starts with a universe of relatively liquid U.S.-listed junk bonds. To be included, bonds must have at least $500 million outstanding, and they can't have defaulted or currently be in distress. The index then scores bonds based on how their cash flow compares with their industry sector peers—any with negative cash flow are removed.
Cash flow, says WisdomTree, can be a smoking gun regarding whether a company might eventually experience financial hardship. Firms with falling or negative cash flow often must scramble to meet debt obligations and keep their businesses running smoothly. A sustained cash crunch may hint at deeper problems.
As a liquidity screen, WFHY's index also removes the 5% of bonds from each sector with the smallest size and longest time since issuance. The index then tilts toward income, ranking bonds according to several risk factors, including default risk. This ranking serves as WFHY's weighting. Companies with higher income are weighted more heavily. In addition, no individual issuer may account for more than 2% of the index.
Screening junk bonds by cash flow isn't a new strategy: Since 2007, the PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB) has done just that. However, PHB uses cash flow as just one of many fundamental screens; also, PowerShares' fund has no intentional income tilt.
IQ Enhanced Core Plus Bond U.S. ETF
As investors struggle to eke out returns in a low-rate, low-yield environment, momentum investing—a well-established strategy in the equity markets—has gained traction as a fixed-income strategy.
Essentially, momentum investing seeks to capitalize on prevailing market trends by overweighting securities that have performed well recently while underweighting poorer performers.
With AGGP, IndexIQ offers investors a way to implement momentum strategies across several sectors of the bond market.
AGGP is a fund of funds that invests in ETFs across several U.S.-based bond sectors, including Treasurys of all maturities, investment-grade and high-yield corporate bonds, U.S. dollar-denominated emerging market debt, even mortgage-backed securities.
Funds are weighted by their total return momentum; sectors with higher momentum carry higher weighting in the index. Momentum is calculated by comparing the 45- and 90-day moving averages of each bond versus those of its sector, while also taking into account the sector's recent volatility. The index rebalances monthly.
Exposure to investment-grade credit and Treasurys is capped at 50%, while exposure to high-yield bonds is capped at 25%. Emerging market debt is capped at 5%. For what it's worth, some of the fund's highest historical weightings have been in investment-grade corporate bonds and mortgage-backed securities.
Though AGGP is one of the first ETFs to apply momentum investing to bonds, it isn't the only one. The SPDR Dorsey Wright Fixed Income Allocation ETF (DWFI) is also a fund-of-funds, momentum-factor bond ETF. However, DWFI only invests in other SPDR ETFs, whereas AGGP pulls from a wide universe of U.S. bond ETFs.
Principal Price Setters Index ETF
Warren Buffett once famously said that when picking stocks, a company's management team mattered less to him than its pricing power, or the firm's ability to raise prices without affecting demand.
The idea makes sense: Companies with plenty of pricing power tend to face little competition in their markets. They can easily pass through cost increases to their customers, unlike firms that rely on competitive prices to attract and retain customers. Strong pricing power, therefore, can translate into sustainable sales and earnings growth, even during market downturns.
However, pricing power isn't easily quantifiable. As such, it's a tricky concept to use as the basis for an index product.
That hasn't stopped one fund from trying, however. The new PSET is a smart-beta fund that aims to track U.S. mid- and large-caps primarily by their pricing power.
The index pulls securities from the Nasdaq US Large Mid Cap Index and ranks them based on 11 factors, including sales growth, operating margins, return volatility, return on equity and earnings quality. (Interestingly, market share is not taken into account.)
The 11 factor scores are then averaged into one final score to determine pricing power. The top 150 securities make it into PSET's index.
Holdings are equally weighted within three rankings tiers: The top 50 securities comprise 50% of the index; the securities ranked from 51 to 100 comprise 35%; and the securities ranked from 101 to 150 comprise 15%. The index rebalances annually.
With no sector caps in place, PSET's portfolio could drift away from the composition of the broad U.S. market. For example, as of Sept. 23, 2016, industrials comprised the biggest portion of PSET's index (28%), whereas they only make up 13% of the S&P 500.
Janus Small/Mid Cap Growth Alpha ETF
Even though growth investing is essentially a bet on the future, many investors sell off their growth stocks as soon as markets become volatile, resulting in missing out on the long-term upside of such companies. After all, you have to give a growth stock time to, well, grow.
JSMD aims to soothe jittery nerves with what Janus calls "smart growth," or a growth strategy that stays the course in volatile markets, so as to capture potential long-term outperformance.
JSMD is based on the popular actively managed Janus Triton Fund, with a passive indexing twist.
The fund's index evaluates U.S. small- and midcap stocks based on their fundamentals in three key areas: growth, profitability and capital efficiency. Janus scores companies for each of these three factors using 10 financial indicators, including revenue growth, margins, profits, return on capital and earnings per share. Then the three scores are totaled to give one final ranking. The top 10% stocks are included in the index.
JSMD's index weights holdings by sector, so as to match the sector allocations established in the Triton Fund. (Within each sector, stocks are market-cap-weighted.)There are no sector caps, but no one individual company may comprise more than 3% of the index.
So is JSMD passive, or active? A little of both. However, at 0.50%, JSMD's expenses come in 41 basis points lower than the active fund on which it's based, which should make the ETF more attractive to comparison shoppers.
WisdomTree Dynamic Currency Hedged Int'l Equity Fund
Whenever you invest in a foreign stock, you also—intentionally or not—take on currency risk. That's why many investors use hedges to cancel out the effects of local currency on their international portfolios.
But currency risk isn't always a bad thing. If you hedge, you may miss out on occasions when moves in the local currency could have boosted your returns.
DDWM aims to capture this lost opportunity by using variable currency hedges. These hedges, which change month to month, are cued by three equally weighted signals.
DDWM's index includes dividend-paying stocks from 21 international developed markets, excluding the U.S. and Canada (and South Korea). Stocks are weighted by the total cash dividends paid over the past 12 months.
The index also rebalances annually, so that companies with falling stock prices but flat or rising dividends are weighted more heavily than those with rising stock prices but falling dividends.
A hedge amount between 0 and 100% is then calculated for each local currency. For example, as of Sept. 23, 2016, the fund was 50% hedged to the euro and Japanese yen, but 83% hedged to the British pound.
To determine each hedge ratio, WisdomTree compares the local currency to the U.S. dollar using interest rate differentials (or "carry"), momentum and valuation.
This hedging strategy is similar to the iShares Adaptive Currency Hedged MSCI EAFE ETF (DEFA), which implements hedges stepped in 25% increments. DEFA also calculates its hedge amounts using similar metrics: carry, momentum, value and volatility.
DDWM, however, tracks a fundamentally weighted index specifically slanted toward dividend-paying companies, whereas DEFA's benchmark is a hedged version of the market-cap-weighted MSCI EAFE Index.
REX Gold Hedged S&P 500 ETF
Gold hedging's popularity has grown as investors seek ways to protect their equity allocations from weakness in the U.S. dollar. However, few gold-hedged equity products have come to market.
Until recently, there was only one: the Etracs S&P 500 Gold Hedged Index ETN (SPGH). That note, which for years struggled to attract significant investor interest, was finally called in August.
GHS hopes to succeed where SPGH failed. The newer fund is an actively managed ETF offering 100% long exposure to U.S. large-caps as well as gold.
It references the same index used by SPGH, the S&P 500 Gold Hedged Index, though as an active fund, GHS is under no obligation to replicate it exactly. This index tracks an equally weighted mix of S&P 500 stocks and near-term gold futures, meaning, should gold and stock prices rise together, GHS' returns will be amplified.
That de facto leverage is no small potatoes: Year-to-date, the gold-hedged version of the S&P 500 has outperformed the vanilla one by almost 29 percentage points (36.4% versus 7.5%).
Interestingly, GHS, unlike its benchmark, can invest in futures contracts across the yield curve, as well as ETFs and ETNs. That could make a difference when it comes time to "roll" contracts (that is, selling expiring contracts and purchasing new ones.) In fact, GHS' managers say they may try to maximize roll yield and minimize costs by buying whichever contract offers the largest positive (or smallest negative) yield. However, there's no guarantee the managers will follow this strategy.
One final note worth keeping in mind: To access the gold markets, GHS uses a Cayman Islands subsidiary, which circumvents the need for the special structure typically associated with exchange-traded gold exposure, but adds its own brand of risk.