"Year of the Quant ETF" In 2008

January 24, 2008

Plain-vanilla quant funds outperform more exotic fare.

If last year was the coming out party for bond exchange-traded funds (ETFs), then 2008 is lining up as the "Year of the Quant Stock ETF."

After years of anticipation, three prospectuses for active equities ETFs were filed in the second half of 2007. In addition, a majority of the 451 ETFs and exchange-traded notes (ETNs) currently on file with the Securities and Exchange Commission (SEC) involve some form of quantitative or alternative methodology to index construction.

It's a wave that's sure to transform a $572 billion industry which has been growing by leaps and bounds, spurred by a more flexible trading platform than traditional index mutual funds.

Last year was no exception. Rising volatility in almost every stock sector and a spreading meltdown in credit markets made analysis of ETFs along broad style categories difficult. But if one generalization rings true, it's that growth of any market-cap size did better than value-oriented funds.

A closer look at individual ETF results, however, shows that 2007 was a relatively strong year for more plain-vanilla quant funds. Others, trying to be more exotic in theme and screening methods, tended to find a rougher go of it. In many cases, quant funds pushing the envelope by so-called "investing between indexes," fell badly behind the broader market.

The Blue Chip Leaders

Take large-cap core styles, the most scrutinized and liquid part of the U.S. stock market.

Top gains were turned in by the Claymore/Ocean Tomo Patent ETF (AMEX: OTP). It returned 17.4% in 2007 by implementing a quant process that screens for companies showing histories of holding "high-quality patents." The top 300 are then weighted in the portfolio according to market-cap size.

OTP held less than 1% of its assets in Financials, which were rocked by a meltdown in subprime mortgage markets in the second half of the year. The ETF also held relatively little in consumer staples and materials stocks. By contrast, it had around 24% in tech heading into the fourth quarter and 18% in health care. Industrials and Energy names also were big contributors.

As a result, the portfolio had a higher price-earnings ratio than the S&P 500. "You've got a large-cap fund with a very growth-oriented portfolio. So you'd expect it to outperform when large growth does well, as it did last year," said Rick Ferri, author of The ETF Book.

He believes that OTP's emphasis on using a theme to invest had more to do with its 2007 results than any quant methodologies thrown into the mix.

"The way they screened stocks happened to come up with companies that overweight sectors that were hot last year. But with a 4% annual turnover rate, they're going to keep buying these same types of companies," Ferri said.

Assuming the ETF's theme remains the same over the long run, Ferri says "it's fair to expect OTP to underperform when value rebounds."

At least in 2007, more traditionally constructed stock ETFs didn't fare as well as many quant funds. Along those lines, iShares Morningstar Large Core (NYSE Arca: JKD) gained 8.5%. Meanwhile, Vanguard Large Cap ETF (AMEX: VV) was up 6.4%, SPDR Dow Jones Wilshire Large Cap (AMEX: ELR) made 6.2% and iShares S&P 500 (NYSE Arca: IVV) finished with a 5.4% return.

Year of Quant ETF?

Before claiming 2007 as the year of the quant ETF in stock markets, consider the divergence within the group. Even among the undisputed leader of the pack in terms of numbers of offerings, last year saw a wide assortment of different returns.

At the end of last year, PowerShares has 43 different quant funds. Almost all of those were based on so-called Intellidex benchmarks. Besides using more valuation and risk ratios to select stocks than traditional market-cap index funds, these ETFs can reconstitute their portfolios more often as well.

Perhaps the clearest comparisons between such quant strategies and more passive ones can be made by drilling below the surface of broad-based, well-diversified portfolios from both camps.

The PowerShares Dynamic Large Cap Value ETF (AMEX: PWV) certainly fits that bill. It boasts extremely low turnover rates and actually has a broader investing universe than a similar rival such as the iShares Russell 1000 Value Index ETF (NYSE Arca: IWD).

The difference in stock-picking methodologies, however, creates divergent portfolios. While IWD has 600-plus different stocks, PWV holds around 50. Also, the Intellidex quant fund has been more skewed toward Financials and Health care while IWD has tended to hold more Industrials and Energy.

Even more to the point last year was that PWV held a much larger contingent of mega-cap firms. That meant it benefited more from a shift in sentiment to bigger blue chips.

It's not surprising that returns last year were much different, with PWV gaining 5.3% and IWD losing 0.7%.

Transparency Makes A Difference

But what about parts of the market that had a better 2007? Well, PowerShares Dynamic Large Cap Growth ETF (AMEX: PWB) also outgunned its closest traditional competitor. It gained some 12.2% last year. By contrast, the iShares Russell 1000 Growth Index (NYSE Arca: IWF) returned about 11.6%.

"The quant ETFs that match up closely to traditional market-cap indexes did well in 2007," said Anthony Welch, an advisor at Sarasota Capital Strategies in Osprey, Fla.

Another top performer in 2007 among diversified large-caps was Claymore/Zacks Sector Rotation ETF (AMEX: XRO), which returned 15.4%. It implements a quantitative approach as well. The fund reconstitutes every quarter and tries to pick out 100 of the S&P's names based on fundamental bottom-up factors such as relative value and earnings estimates. It also throws in macroeconomic factors in Zack's computer-generated ratings systems.

"It's more transparent than a lot of quant ETFs," Welch said. "You know they're trying to invest in the hot sectors, which is a broader strategy than picking hot stocks. So it has less risk potential."

A more oddball quant fund he owned last year was PowerShares Dynamic MagniQuant ETF (AMEX: PIQ). It returned 1.7% in 2007. The closest comparisons listed by PowerShares were indexes tracked by iShares Russell 3000 Index (NYSE Arca: IWV) and the S&P 500-tracking SPDRs (AMEX: SPY). In 2007, IWV made 4.6% and SPY gained 5.4%.

"The MagniQuant is a hard ETF to track," said Welch. "The strategy of creating a unique new index of its own seemed innovative. We were at least willing to give it a chance."

Not All Quants Are Alike

He still likes many PowerShares products. "But the whole quant trade has become very crowded," Welch noted. "When the economy really started heading south last summer, a lot of these newer niche quant strategies got hammered."

He added: "We don't have a clue what some of these more proprietary quant strategies are doing. We prefer to have a little better grip on what could impact its performance. So with quant funds, we really emphasize transparency."

Quant funds usually have more volatility than more static indexes. And indeed, this year, PWB has fallen harder than IWF as market conditions continue to deteriorate. "That's something you've got to consider," said Welch. "The PWB ETF's standard deviation, which is a measure of volatility, is about 10% greater than the equivalent Russell 1000 Growth Index ETF. So when the market's up, it should outperform."

In the coming 12 months, providers are lining up to cram even more quant funds into the marketplace. They've come up with all sorts of niche indexes, many of which provide exposure to illiquid and highly volatile markets formerly only open to well-capitalized institutional investors.

As a new crop of funds gains popularity by implementing the latest in computer-generated portfolio construction, skeptics point out that proposals under registration still don't go as far as the freedoms open-end mutual fund managers have to set their own stock-picking parameters.

Still, most quant funds use a myriad of ratios and valuations to screen for stocks that traditional ETFs don't ever consider. This is accomplished by letting computers perform most of the heavy lifting in the selection process.

At least in theory, such high-tech number crunching means more variables can be considered in developing an index. Since quants are highly mechanized, they also can rebalance and reconstitute portfolios more regularly.

Only Time Will Tell

And that's where the quant ETF argument is supposed to come to full fruition. After all, if an index can be replenished by a mere push of a button or two, then concerns about time and waste impacting returns are automatically eliminated.

Traditional indexers argue that simplicity will win out over time. Just pick the names with the greatest market-cap sizes and weight them accordingly. Let the market cast its votes in the form of how much of whatever number of shares are on the market at any given time.

The debate figures to grow as more quant-based ETFs accumulate longer track records. So far, most are very new entries into an already crowded marketplace. That makes evaluating their value to long-term investors more an art than science.


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