How eight exchange-traded funds separated themselves from their broad markets by vastly outperforming.
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.
More impressive though is that the WisdomTree Japan Hedged Equity Fund (NYSEArca: DXJ) returned more than 40 percent and the db X-trackers MSCI Japan Hedged Equity Fund (NYSEArca: DBJP) rallied nearly 50 percent.
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?
Answer: Currency hedging.
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 (NYSEArca: RYT) and the PowerShares S&P SmallCap Information Technology ETF (NasdaqGM: PSCT) have each returned about 27 percent over the past year when the U.S. tech sector only returned 9 percent.