In the beginning of the ETF industry, there was SPY. From there, the initial wave of expansion included primarily “plain vanilla” equity funds offering exposure to widely-followed benchmarks, such as the Dow, Nasdaq, and even sector-specific indexes. But innovation and product development in the ETF world didn’t stop there. The last five years have seen ETFs expand from a closet industry to a mainstream investment option. And as the popularity of these funds has increased, so too has the available product line. ETFs now provide access to nearly every corner of the investable universe, from fixed income to commodities to hedge fund strategies.
One area of the ETF industry that has seen considerable growth is the “quantitative indexing” space, a concept that begins to blur the line between active and passive management. Many indexes (and therefore ETFs) utilize market capitalization to determine which companies will be included and the allocation afforded to each. Others lean on other fundamental metrics such as revenue, earnings, or dividends in determining components and weightings.
But a growing number of funds are based on more complex, analysis-driven formulas. These ETFs are still passively-indexed, meaning that they enjoy many of the benefits — lower costs and turnover, increased transparency, etc. — that have made ETFs so popular. But the indexes on which they are based use proprietary methodologies in an attempt to identify individual holdings that are poised for outperformance.
There are dozens of funds that fall into this category, with a wide variety of strategies. The First Trust Value Line 100 ETF (FVL), for example, selects 100 stocks from the universe of stocks given a #1 ranking in the Value Line Timeliness Ranking System. The PowerShares DWA Technical Leaders Portfolio (PDP) includes U.S.-listed companies that demonstrate powerful relative strength characteristics, taking into account relative performance in the construction process. The examples go on and on (see this feature for a more in-depth look at some of these strategies).
In 2009, the results for these “intelligent” or “enhanced” products were mixed. While several delivered impressive gains, others failed to beat broad benchmarks. One fund that enjoyed a particularly good year, however, is also one of the most interesting: the Claymore/Sabrient Insider ETF (NFO).
Under The Hood Of NFO
The objective of the index tracked by NFO is to represent a group of companies that are reflecting favorable corporate insider buying trends and Wall Street analyst earnings estimate increases. From a universe of approximately 6,000 eligible securities, 100 stocks are selected for inclusion based on their rankings on these two factors. The index is equally-weighted, ensuring that a handful of mega-caps don’t account for a large portion of total assets.
The tactics employed by NFO are completely legit — the “favorable corporate insider buying trends” that the fund seeks to identify are researched through publicly-available filings of the “insiders.” And the investment thesis behind the fund is simple enough to follow: basically this strategy attempts to draft the moves of two groups who are closest to the companies analyzed. Peter Lunch, the legendary former manager of the Magellan Fund, perhaps said it best: “Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.”
Likewise, by analyzing changes in earnings estimates from Wall Street analysts, investors can potentially throw their holdings behind companies that may beat expectations. Since equity analysts often devote significant time to researching and analyzing a single company, they can often be among the first to identify reasons for performance that could exceed consensus expectations.
The theory may be sound, but in the ETF world it’s results that matter. And in 2009 NFO posted pretty solid results, outperforming traditional market capitalization-weighted benchmarks by a wide margin. NFO is up nearly 50% on the year, nearly doubling S&P 500 ETFs and more than 10% ahead of mid-caps.
Benchmarking NFO is a bit of a challenge because its exposure is spread across small, mid, and large caps. But regardless of the comparison, NFO is putting together a nice little track record. Since its inception in September 2006, the fund has gained 3.7%. While this might not be impressive in absolute terms, it seems stellar relative to more popular options for gaining domestic equity exposure. SPY has lost 15% over the same period, while the SPDR MidCap Trust (MDY) is down about 3% and the iShares S&P SmallCap 600 Index Fund (IJR) is off more than 10%.
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Disclosure: No positions at time of writing.