Enhanced-index ETFs are based on indices that use alternative metrics.

Traditional ETFs track indices that proportionately weight companies according to market capitalization. Enhanced-index ETFs track indices created using metrics such as price-to-cash-flow ratios, dividends or earnings, in order to exploit market anomalies.

Bobby Eng of FT Portfolios Canada Inc. says market-weighted indices “weight securities based on their size, not investment merit. Traditional index ETFs provide returns that mimic the market-cap weighted indices—beta—while enhanced-index ETFs are looking for returns over and beyond the traditional market-cap weighted index—alpha.”

Howard Atkinson of Horizons ETFs adds market-cap weighted indices are useful in growth strategies, but not value strategies in which investors try to buy “companies temporarily out of favour in the market.” That’s because with market-cap weighting, larger companies are weighted higher and tend to be growth stocks.

“So investors who already have the top three sectors [energy, financials and materials] well represented in other investments might choose an index weighted by fundamental factors. Enhanced index products provide additional exposure to the seven other GICs sectors by weighting constituents according to factors like PE ratios, price-to-sale ratios or dividend growth, payout and sustainability.”

Using these products can lead to better risk-adjusted returns.

Building an enhanced-index ETF

  1. An index provider finds an exploitable market anomaly.
  2. The index provider then works with an ETF provider to create a product. The ETF provider would determine if the strategy could be replicated in a product, if there is enough liquidity in the market, whether the product would reach a profitable size, and whether it could it be offered at a reasonable cost. Other factors, such as potential tracking error, are also considered.
  3. The ETF provider creates the product and prepares a prospectus, and files it with the relevant authorities.
  4. Once regulatory approval is received, and the ETF provider has found a suitable designated broker, it can start offering the product.

Source: Pat Chiefalo of National Bank Financial

“Academics have shown an equally weighted or an [alternatively weighted] index has outperformed the traditional market-cap weighted index on average, which has caused a proliferation of alternative types of indexing,” says Larry Berman, Chief Investment Officer, ETF Capital Markets.

A January 2013 study conducted by Research Affiliates found the S&P Low Volatility Index earned an annualized return of 10.2% since inception, compared to 8.7% over the same period for the S&P 500. As well, “During the two most recent market collapses…the low volatility strategies significantly outperformed traditional cap-weighted investing while maintaining the desired low risk profile.”

Pat Chiefalo, director of Derivatives and Structured Products for National Bank of Canada, adds, “Investors can use enhanced-index products to access different risk profiles for a particular market, including lower volatility or higher beta.”

Berman adds enhanced-index ETFs are intended for long-term investors because it can take years for alpha to play out in the market. Smart indices weed out poorly performing stocks over time.

Enhanced-index ETFs also tend to be less liquid. “So they would not suit an active trader with many buys and sells,” he says. “They would get expensive quickly.”

Types of indices

The simplest enhanced ETF tracks an equal-weight index, where all constituents are held equally. For example, Royal Bank has an 8% weight by market cap in the S&P/TSX 60, but in an equal-weight index it would have a 1.7% weight.

“Equal-weighted index ETFs tend to do well as the market broadens out,” says Atkinson.

As for more complex indices, there is now a covered-call version of the S&P 500 that writes call options on individual stocks to increase income from a core U.S. equity holding. The calls are sold out-of-the-money at prices determined by each stock’s implied volatility, which tends to be higher than the volatility of the index as a whole, and therefore should generate more premium income.

He adds some ETFs track the Auspice Managed Futures Index, which consists of 21 non-equity futures contracts, including currencies and commodities. Contracts can be long or short. Correlation with the equity market is slightly negative, making these ETFs good diversifiers. “Managed futures had a great year in 2008. Even 5% exposure would have offered good downside protection,” says Atkinson.

What to tell clients

› All ETF funds have an underlying index. The rules make the difference between traditional and enhanced ETFs.

› Explain the weighting methodology of the index, and how the index is expected to perform. Also explain the liquidity of the underlying securities.

› Pat Chiefalo of National Bank Financial says enhanced-index ETFs let retail investors access different risk-return profiles from traditional ETFs. For instance, emerging markets tend to have higher volatility and enhanced products offer a means to achieve equity exposure with better risk-adjusted returns.

› Enhanced indices can add alternatives to the equity portion of a portfolio core.

› The strategies embedded in these ETFs can take years to play out.

Lisa MacColl is an Ontario-based financial writer.