Exchange-traded funds haven't been around for very long and many investors still don't understand them. While many are a plain-vanilla type investment, some offer an allocation that could significantly enhance a portfolio.
Many ETFs are based on an index and are passively managed. They have gained popularity because they are diversified, easy-to-trade, tax efficient and cover many hard-to-access asset classes. While many investors use mainstream ETFs, there is a different classification of ETFs some investors do not know about called an enhanced index ETF.
An enhanced index takes one of the typical indices and reduces the securities down to the best of the best using a formula.
A standard ETF may be based on the S&P 500 index, a weighted average of 500 stocks said to represent the largest companies traded on the stock exchanges. It is a representation of the market, but because it is weighted, a majority of the index value is contained in a small number of stocks.
An enhanced ETF could begin with the same index, but possess several formulas that potentially change the number of stocks and the value contained in each. For example, the first formula that enhances the index could change from one that is weighted to one that is evenly distributed. A second formula could rank the 500 companies according to sales, book value, net profits or even dividends. From that formula, the fund may limit the investment to the top 50 stocks of the ranking. Securities could be rescreened several times throughout the year to ensure they still fit the formula criteria.
There are many types of enhanced ETFs and the formulas they use come in many shapes and sizes. Here are a few of the screening strategies that whittle a broader index down to stocks you actually want to own:
- Weighting. Cap‐weighted indices force investors to own companies that make up a dominant percentage of an index sometimes. Owning an enhanced, non‐cap‐weighted ETF gives you greater exposure to stocks that may be undervalued but that still provide alpha. Because of their diversification equally among the components of the index, volatility can be limited.
- Qualitative. Markets have a tendency to dislocate from fundamentals. Using an enhanced ETF as an unbiased tool that screens out some of the more overvalued stocks while allocating a larger percentage towards those that are undervalued can be beneficial.
- Quantitative. The knock on passive ETFs is that they can't keep up with a faster, more volatile market—something a professional, active manager would be able to act on and capitalize on. Enhanced ETFs that use quantitative strategies can help investors take advantage of these faster moving, volatile markets.
- Rebalancing. Most enhanced ETFs rebalance their weightings on a periodic basis. Rebalancing helps lock in gains from stocks that have performed well and buy those that have not.
- Long/short equity. ETFs typically buy and hold stocks. A long/short ETF will buy 'long' certain equities believed to be increasing in value and sell 'short' those believed to be decreasing in value.
It takes a little extra work to find the perfect enhanced index ETF for you, but it could definitely be worth the effort. Now that you know about enhanced indexing, you have a leg up on all those passive ETF investors.
Good luck and happy investing.
Kelly Campbell, Certified Financial Planner and Accredited Investment Fiduciary, is founder of Campbell Wealth Management, a Registered Investment Advisor in Fairfax, Va. Campbell is also the author of Fire Your Broker, a controversial look at the broker industry written as an empathetic response to the trials and tribulations many investors have faced as the stock market cratered and their advisers abandoned their responsibilities to help them weather the storm.