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The Top ETFs Over Three Years: Consumer Spending Makes an Impact

by Charles Rotblut, CFA

This is the third year we have compiled and analyzed the top-performing exchange-traded funds (ETFs).

Only one ETF has made the list of the 10 best performers in all three years: SPDR S&P Retail fund (XRT). The fund’s three-year annualized gain of 30.6% ranks third among all exchange-traded funds. Its three-year performance ranked eighth in 2012 and third in 2011.

Notably only one other ETF retained its top-10 ranking from last year: PowerShares Dynamic Pharmaceuticals fund (PJP). The ETF realized a 33.5% annualized gain over the past three years, the best performance of any ETF over that time period. Last year, the fund ranked sixth among all funds.

What’s notable about the two funds is that they follow two very different types of indexes. SPDR S&P Retail follows an equal-weighted index. PowerShares Dynamic Pharmaceuticals follows a rankings-based index. Companies for PowerShares Dynamic Pharmaceuticals’ underlying index are selected based on a variety of criteria including price momentum, earnings momentum, quality, management action and value. The differences between the two index’s methodologies show that no one single methodology has universally proven to be the best over the past few years.

The two funds also show the difficulty of solely picking ETFs based on recent sector performance. This year’s top-10 three-year rankings show a significant turnover from last year not only in terms of the funds, but also in terms of the categories they represent. Last year’s top-10 list featured six real estate funds; this year’s list contains none. Instead, the category breakdown for this year’s top-10 rankings is as follows: health (3), consumer discretionary (4), homebuilders (2) and mid-cap (1).

As is the case with mutual funds, the return realized by an ETF is primarily influenced by its investment objective. If the category, industry group or style a fund is designed to follow does well, the fund’s performance will benefit. We saw this play out with the consumer discretionary category. The sustained economic rebound has prompted consumers to open their wallets more, as seen in the growth of retail sales over the past three years. This in turn has given a boost to both retailers and other companies that benefit from consumer discretionary spending. SPDR S&P Retail has been an obvious beneficiary of this trend, but so have fellow top-10 performers PowerShares Dynamic Leisure & Entertainment fund (PEJ), Vanguard Consumer Discretionary fund (VCR) and Consumer Discretionary Select Sector SPDR fund( XLY). These three sector funds invest in media, travel, automobile and restaurant companies as well as retailers.

No Overall Trends in Equity Funds

In writing this year’s analysis, I looked at the broad stock categories to see if there were any discernible trends I could point out. Though there were pockets of outperformance, there was not a single investment style or indexing methodology that held across most categories.

Dividends provide a good example. Three dividend-oriented funds—WisdomTree Dividend ex-Financials fund (DTN), WisdomTree Equity Income fund (DHS) and Vanguard High Dividend Yield Index ETF (VYM)—ranked among the large-cap stock category’s best-performing funds for three years. In the foreign stock category, WisdomTree International SmallCap Dividend fund (DLS) and PowerShares International Dividend Achievers fund (PID) were the best and third-best performing funds, respectively.

In other stock categories, the investment style of the top-performing funds differed. The mid-cap category contains a combination of value, growth, core and alternative styles. Three of the small-cap category’s top performers over three years are growth-oriented funds. Europe, Latin America and Pacific/Asia are dominated by country-specific funds. (Not surprisingly, given the continent’s sovereign debt problems, the top-performing European funds focused on northern European countries: iShares MSCI Switzerland Capped Index fund (EWL) and iShares MSCI Sweden Index fund (EWD).

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The Strong Returns of Spin-Offs

Guggenheim Spin-Off (CSD) was the 10th best-performing fund, with a three-year annualized total return of 26.0%. The fund also ranked in the top quartile of all mid-cap ETFs in 2009, 2011, 2012 and during the first half of 2013 (returns shown in bold). Its performance during the last bear market, however, was disappointing. The fund lost 63.0%, versus a 53.0% drop for the average mid-cap exchange-traded fund.

As the name implies, Guggenheim Spin-Off invests in companies that have been spun-off within the past 30 months. These are companies that have been separated from their parent companies either through a spin-off distribution of stock or a partial initial public offering. These types of corporate events occur when the board of directors believes value can be unlocked by separating a subsidiary or an operating division from its parent company.

Though not a pure mid-cap fund, Guggenheim Spin-Off primarily invests in companies with market capitalizations below $10 billion. Inclusion of companies into the underlying index is based on a proprietary scoring system that considers several growth-oriented factors. The emphasis on growth would explain why the fund has performed well during the ongoing bull market, but lagged during the previous bear market.

How Rising Yields Affected Bonds

The best-performing bond ETFs mostly realized single-digit annualized returns over the past three years. Adversely affecting their performance was this year’s rise in interest rates, which increased yields and lowered bond prices. Though this fact may not be surprising, the other trend we noticed might be.

Many of the top-performing bond funds experienced differences between their 12-month net asset value (NAV) return and their 12-month market (share price) return. For example, the SPDR Barclays High Yield Bond fund (JNK) realized a total return of 7.7% on a NAV basis, but just 6.8% on a market basis. The Market Vectors Intermediate Muni ETF (ITM) lost 0.9% on a NAV basis, but fell by 2.9% on a market basis.

The separation in performance has to do with the underlying liquidity of these fund’s holdings. As institutional investors and market makers react to rising yields by redeeming ETF creation units (large blocks of ETF shares), ETF sponsors can find themselves in the position of having to sell bonds into difficult market conditions. A report issued by Fitch Ratings last month noted that “the only heightened incidence of ETF discounts occurred in this most recent quarter, given the fixed-income market pressures experienced in May and June.”

This occurrence demonstrates the importance of considering how closely the market return and the NAV return match. Notable differences between the two can point to lower levels of liquidity in the underlying assets. As is the case with closed-end funds, mispricings can create opportunities and risks. Share prices below NAV imply you are paying less than a dollar for a dollar’s worth of assets. Share prices above NAV imply you are paying more than a dollar for a dollar’s worth of assets. Differences between the market price return and NAV return imply the fund is performing better or worse than the underlying value of its assets.

Caveats & Notes

A three-year period has been used for ETFs because many exchange-traded funds still lack five-year histories. Though many large-cap domestic stock ETFs have been around for longer than five years, too many funds from other categories would have been excluded had we required five years of return history instead of three.

I do eventually intend to change from a three-year to a five-year period to provide a closer comparison with the annual listing of the best-performing mutual funds (“The Top Mutual Funds Over Five Years: The Bear’s Claw Marks Remain,” March 2013 AAII Journal). The comparisons will not be completely similar, however, because of the six-month difference in the time periods analyzed. Though seemingly short, it can make a difference in terms of which fund categories are represented in the top-10 lists. Keep in mind that a six-month shift not only picks up six new months of performance, it also drops six months of older performance. (We use this split to keep the top fund data comparable between the ETF guide, which is published in July, and the mutual fund guide, which is published in February.)

The top-performing funds for nearly every category are now displayed, matching the format of last issue’s ETF Guide. This is a change from last year, when some of the categories were combined. Due to the growth and maturity of the ETF industry, there are now enough funds to justify the more detailed breakdown.

The overwhelming majority of exchange-traded funds continue to be passively managed. Though there are some actively managed ETFs, most have not gathered significant levels of assets under management (AUM). They also are relatively new, with limited investment histories. This is why the largest actively managed exchange-traded fund, PIMCO Total Return fund (BOND), will be excluded for a few more years even though it had more than $4.1 billion in AUM as of June 30, 2013. (The fund was incepted in February 2012).

Nonetheless, there are enough similarities between ETFs and mutual funds to warrant considering both when purchasing a fund. Mutual fund and exchange-traded fund returns are significantly influenced by broad market, asset preference and category-specific trends. In some cases, passive strategies are the best way to take advantage of these trends, favoring ETFs. In other cases, active management is better, favoring mutual funds. Looking at the longer-term performance of both types of investments makes the decision process easier by dampening the short-term market noise that can distort the numbers.

Always keep in mind that fund analysis involves more than just looking at total return. Performance relative to a fund’s peers, the fund’s volatility, the composition of the fund, the strategy used, expenses and size are all important factors. Proper diversification is also very important; you need to seek out the fund or security that best fulfills your diversification needs. Furthermore, look at the fund’s portfolio, the index it is designed to follow and the weighting strategy used. An ETF’s risk cannot be judged by the fund’s name alone.

Which Funds Were Included

I largely restricted the list of top ETFs to those with three years of annual return data and a minimum of $250 million in assets. (Exceptions were made when the performance of a smaller fund warranted it.) Funds that use leverage to provide double or triple the return of their underlying index or that follow inverse strategies (they rise in price when the underlying index falls) were excluded from consideration. These funds are designed to be held for short periods of time, not several years.

Table 1 on pages 26 through 31 shows the top ETFs by category. Three-year performance was calculated through June 30, 2013, to match the statistics displayed in “The Individual Investor’s Guide to Exchange-Traded Funds 2013,” which was published in the August 2013 AAII Journal.

In addition to three-year performance, returns for the year-to-date, the last 12 months and each of the past five years (where available) are displayed, along with returns for the most recent bull market (March 1, 2009, through June 30, 2013) and bear market (November 1, 2007, through February 28, 2009), where available. Returns that are in the top 25% of all ETFs within their investment category are shown in boldface. Other pertinent information is presented, including yield, tax-cost ratio, risk, portfolio composition and expenses. Risk numbers that are in the lowest 25% of all ETFs within the investment category are shown in boldface. Twelve-month and three-year annual total returns based on market value are also displayed to show how closely each fund’s price performance matches its net asset value performance. The bigger the difference, the larger the premium or discount shares of the fund have traded at over the period.

Look Beyond Performance

There is always a temptation to look more favorably at the best-performing funds. Though performance does matter, it is just one factor to consider.

You should also consider your portfolio needs. A basic allocation of ETFs holding domestic stocks with varying market capitalizations, international stocks, government bonds, corporate bonds and international bonds will serve most investors well. Once this basic portfolio allocation is established, other asset classes—such as real estate and commodities—and more specialized funds can be added.

Sector and country funds can boost a portfolio’s returns, but prudence is required when using them. Make sure you understand the factors that have driven a sector’s performance over the past few years and how likely it is that those trends will continue in the future. You cannot safely navigate a winding road by only using a rear-view mirror. Country-specific ETFs can allow you to target specific markets, but can be more volatile and expose you to exchange-rate risks.

Be sure you fully understand the index that the ETF is designed to follow. Similar sounding indexes can have different return characteristics. They can also either hold different stocks or weight the same stocks differently. A quick visit to an ETF family’s website can give you the list of current holdings and information about the underlying index. Many index providers also give more detailed information about their indexes on their own websites. (Type in the index’s name into an Internet search engine, such as Google, to find the specific website.)

Finally, use this rule of thumb when looking at ETFs: “Just because you can invest in something doesn’t mean you should.” Buy only those ETFs that you fully understand; avoid those tracking indexes or investing in sectors or countries with risks that you cannot identify.

Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/CharlesRAAII.


Discussion

H Jagannath from FL posted 12 months ago:

I was wondered about dividend paying stock or best dividend etf to generate monthly dividend.thanks


Winston Pearson from GA posted 11 months ago:

I would suggest, depending on amount of money available, various stocks that pay quarterly, but pay in different months so that you get a monthly check. You could get 12 checks a year with just 3 stocks.


Robert Rutherford from WA posted 11 months ago:

Why is BAB listed under the 'Muni Nat'l Bond: Long Term Cat Average' category? Isn't it a taxable bond fund, i.e., the distributions are treated as ordinary income?


Charles Rotblut from IL posted 11 months ago:

Hi Robert,

The fund is listed under Muni Nat'l Bond because, according to Morningstar, it invests in taxable municipal bonds.

-Charles


Christophe Couallier from FL posted 9 months ago:

How would you screen for ETFs to build a portfolio? Looking for ways via the excel table attached with the article. Thanks.


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