With shiny rearview mirror in hand, here’s a survey of 2014’s ETF leaders and laggards, viewed through the steely eye of risk-adjusted outperformance, or alpha.
At ETF.com, we compare each ETF’s performance with a benchmark index that’s consistent with the fund’s broad goals. A related term, “beta,” describes the amount of risk the fund is taking relative to the market. If the ETF takes a lot more risk by loading up on small-caps or on volatile stocks, for example, it has high beta, but it might not earn alpha even if its returns are higher than the market.
Alpha accounts for returns that aren’t explained by market risk or beta. The alpha must be meaningful statistically so that the excess returns unexplained by market risk (beta) are due to the fund’s attributes, not luck.
Alpha can be positive or negative, as shown below. ETFs that leaned toward small-caps suffered. So did “momentum” plays, which aim to ride the hot stocks. More surprising to me was the resurgence of low-volatility (aka minimum-variance) ETFs.
I’ve confined the list to U.S. ETFs. Very narrow sector plays dominate the extremes of the list, so I held those out separately. Here’s a summary of alpha heroes and goats.
2014’s Alpha leaders In U.S. ETFs (Except Sector ETFs)
iShares MSCI USA Minimum Volatility ETF (USMV | A-64)
Alpha: 7.36 percent versus ETF.com benchmark: MSCI USA Investable Markets Index
Did the low-vol anomaly of spring 2013 return in autumn of 2014? Yes, according to USMV. The fund took much less risk than the market measured by beta, but still beat it—a neat trick. USMV avoided the broader market’s fall swoon as it overweighted utilities and went light on the cratering energy sector.
Can you count on such prescience in 2015? Not in my book, but you can count more on lower volatility than the broad market at a very low all-in cost.
SPDR Russell 1000 Low Volatility ETF (LGLV | B-64)
Alpha: 5.57 percent versus ETF.com benchmark: MSCI USA Large Cap
LGLV confines itself to the large-cap space, but like USMV, it pulled away from the market in October. One caveat: LGLV costs more to trade than SPLV or USMV, and has a tiny asset base.
iShares MSCI USA Size Factor ETF (SIZE | B-76)
Alpha: 5.24 percent versus ETF.com benchmark: MSCI USA Investable Markets Index
SIZE is misnamed: Low vol lives here too. Yes, the fund tilts toward smaller firms, but it also weights its stocks inversely to volatility. The low-vol tilt shows up clearly in the fund’s low beta. Because the fund pulls from a universe of large- and midcap stocks, the size tilt is confined to an overweight of midcaps (which did OK in 2014) not small-caps (which didn’t).
2014’s Alpha Laggards In U.S. ETFs (Except Sector ETFs)
PowerShares DWA NASDAQ Momentum Portfolio (DWAQ | B-23)
Alpha: -16.71 percent versus ETF.com benchmark: MSCI USA Investable Markets Index
While the tech sector and Nasdaq-listed stocks beat the S&P in 2014, a momentum play based on the tech-heavy Nasdaq lagged badly. When the Nasdaq stumbled in March 2014, DWAQ fell hard and couldn’t make up the lost ground. A hefty slug of small-caps didn’t help. Expect a wild ride either way in 2015 given DWAQ’s sky-high beta.
Guggenheim S&P MidCap 400 Pure Growth ETF (RFG | A-50)
Alpha: -11.69 percent versus ETF.com benchmark: MSCI USA Mid Growth Index
RFG’s pure coverage hurt its returns relative to our top-heavy benchmark. The fund offers “growthy” exposure with a small-cap tilt, while our benchmark is decidedly less growthy and leans hard toward larger firms. The size tilt hurt the fund in 2014, but going forward, RFG represents the midcap growth space as well as any.
PowerShares DWA SmallCap Momentum Portfolio (DWAS | B-47)
Alpha: -11.42 percent versus ETF.com benchmark: MSCI USA Small Cap
DWAS’s tilt toward surging health care wasn’t enough to overcome its overweighting to smaller firms. Here again, our benchmark leans large, while DWAS tilts toward microcaps, which dragged on performance. The fund’s very high beta means it could storm back in 2015—or lag badly again.
2014’s Alpha leader In U.S. Sector ETFs
First Trust NYSE Arca Biotechnology Fund (FBT | B-30)
Alpha: 24.13 percent versus ETF.com benchmark: Thomson Reuters US Biotechnology & Medical Research
FBT’s deviations from pure-play biotech helped to power huge returns in 2014. The fund leans hard toward larger firms (continuing the “pox on small-caps” theme) and also dabbles in pharma. Still, no fund delivers anything close to pure-play coverage in the narrow biotech space. Looking ahead, FBT’s portfolio is smaller but less concentrated than that of the iShares Nasdaq Biotechnology ETF (IBB | A-26) segment giant.
2014’s Alpha Laggard In U.S. Sector ETFs
SPDR S&P Oil & Gas Equipment & Services ETF (XES | A-10)
Alpha: -29.8 percent versus ETF.com benchmark: Thomson Reuters US Oil & Gas Related Equipment & Services
In a year where oil prices plummeted, our equipment and services benchmark was only down about 4 percent, in part due to heavy exposure to the less-price-sensitive oil and gas transportation industry. Like peer funds that also suffered relative to our benchmark, XES has tiny exposure to this industry. But XES has the largest exposure to small- and microcaps, which weighed heavily on returns.
Takeaways For 2015
Alpha is easy to find—in retrospect. Getting the call right looking ahead is another matter, as the failed consensus at this time last year—on interest rates and on oil prices—shows. Small-cap and momentum plays struggled in 2014, but will lead again some year.
My only counsel for 2015: Buy the risks, not the rewards. If you sleep better at night knowing your equity fund has a bias toward low vol, or dividends or left-handed CEOs, then own it and stick with it.
At the time this article was written, the author held a long position in VTI and enjoyed 58 basis points of positive alpha. Contact Paul Britt at [email protected] or follow him on Twitter @PaulBritt_ETF.