The Top ETFs Over Three Years: Health Care Takes Top Four Spots

A few notable things stand out in this year’s list of the exchange-traded funds (ETFs) with the best three-year returns.

First, six of the funds in this year’s top-10 list are holdovers from last year. Second, health care funds control the top four spots and six of top 10 spots in this year’s list. Third, PowerShares Dynamic Pharmaceuticals PJP ranks in the top 10 for the third consecutive year. Fourth, SPDR S&P Retail ETF XRT fell out of the top-10 ranking for the first time since we started compiling the list in 2011.

After having a fairly diversified group of stock funds in last year’s top-10 rankings, this year’s list is fairly concentrated. In addition to the six health care funds (three of which are biotech ETFs), two funds target companies involved in the housing sector. The only two non-sector funds making the top-10 list are First Trust US IPO Index FPX and Guggenheim Spin-Off CSD.

There was a small shift at the very top, with iShares Nasdaq Biotechnology IBB moving from number two to number one and PowerShares Dynamic Pharmaceuticals slipping from the top spot to number two. The shift reflects the comparatively stronger returns realized by iShares Nasdaq Biotechnology in 2012 and 2013. The two funds both list Gilead Sciences GILD among their largest holdings, but their portfolios differ from there. The iShares ETF follows a modified market-cap-weighted index that tracks the performance of NASDAQ-listed biotechnology stocks. The PowerShares ETF follows a tier-weighted index based on factors such as price momentum, earnings momentum, quality, management and valuation. This index tracks the performance of 30 big, specialty and generic pharmaceutical companies.

PowerShares Dynamic Pharmaceuticals realized higher performance during the first three calendar years of the current bull market, while iShares Nasdaq Biotechnology performed better in the most recent two years. However, during the first six months of 2014, the PowerShares fund took back the short-term performance bragging rights. The altering performance differential is a reflection of changing attitudes about risk. Investors tend to be cautious during the early stages of a bull market, but gain confidence and become more risk-seeking as the bull market continues. Earlier this year, we saw a drop in risk tolerances as investors became more concerned about the potential for a drop in stock prices.

Weighting methodologies also play a role. Three of the four top ETFs track alternatively weighted indexes. The PowerShares fund, as just noted, follows a factor-weighted index. SPDR S&P Pharmaceuticals XPH and SPDR S&P Biotech XBI follow equal-market-cap-weighted indexes. These types of indexes allocate a greater percentage to smaller companies, which helps boost relative performance. They can also, however, lead to different, and potentially worse, returns than a traditional market-cap-weighted index. (Market-cap-weighted indexes allocate based on the relative size of each company’s market capitalization, with larger companies having bigger weightings.) I point this out to show the importance of understanding what index a fund follows. ETFs cannot simply be judged based on their names alone.

One odd characteristic about this list of top-10 performers is a similarity in the inception dates: Eight of out of the 10 funds were launched in 2006. This is purely coincidental. Unlike fine wines, funds cannot be judged based on the year they were created. (Last year’s top-10 list contained funds with inception dates ranging from 2000 to 2010.)

Don’t Overlook Year-by-Year Returns

A multi-year return figure smoothes out the fluctuations of annual returns. It also better highlights funds with consistent performance, while penalizing funds that were hot for just one year. Multi-year return numbers are, however, influenced by how a fund performed over each year in the measured period. Therefore, it is important to not only look at the three-year return figure, but also the individual annual returns that it is composed of.

IShares US Home Construction ITB and SPDR S&P Homebuilders XHB are good examples as to why. The ETFs, which rank fifth and 10th in terms of three-year return, performed exceptionally well in 2012. The iShares fund gained 78.9% and the SPDR fund gained 57.5%. Both funds realized losses in the second half of 2011 and during the first half of 2014, however. They also lagged the S&P 500 index in 2013. In other words, their strong three-year return is skewed upward by a very good 2012.

These funds further emphasize the importance of not making assumptions about the holdings strategy of an ETF based on its name. IShares US Home Construction’s five largest holdings are homebuilders such as DR Horton Inc. DRI and Lennar Corp. LEN. The largest holdings of SPDR S&P Homebuilders include home improvement retailer Lowe’s Companies Inc. LOW, home products retailer Williams-Sonoma Inc. WSM and flooring company Mohawk Industries Inc. MHK.

Profiting From IPOs and Spin-Offs

As mentioned, the two non-sector funds in the top 10 are First Trust US IPO Index and Guggenheim Spin-Off. The Guggenheim fund is one of six ETFs maintaining its spot in the top-10 list for at least a second consecutive year.

First Trust US IPO Index tracks the IPOX-100 U.S. Index. This index is made up of the top U.S. companies, ranked by market capitalization, that have completed their initial public offerings within approximately the past four years. Companies are generally added to the index six days after completing their initial public offering. The index caps the weighting of any individual company at 10%.

Starting in 2007, this ETF has ranked within the top quartile for large-cap stock ETFs during five out of seven full-calendar years. However, it performed significantly worse than the large-cap category in 2008, losing 43.9% versus a loss of 36.2% for the average large-cap ETF. Though not a top performer in 2011, First Trust US IPO Index’s 3.1% gain was better than the 2.7% large-cap category average.

The ETF’s expense ratio of 0.60% ranks among the most expensive for all large-cap ETFs. The category average is 0.40%. The comparatively higher expense ratio for the fund may, in part, may be due to quarterly rebalancing of the underlying IPOX Global Composite Index. First Trust US IPO Index’s tax-cost ratio of 0.40% is below the large-cap ETF average of 0.60%, however.

As some of you may recall from last year’s commentary (“The Top ETFs Over Three Years: Consumer Spending Makes an Impact,” September 2013 AAII Journal), 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.

The Guggenheim fund tracks the Beacon Spin-Off Index. This index uses a modified market-cap-weighting methodology to limit the weighting of any single stock to no more than 4.5%. The index is rebalanced annually unless there are not enough new spin-off companies to populate the index. (A decline in spin-offs and IPOs, respectively, are risks for these Guggenheim and First Trust ETFs.)

Guggenheim Spin-Off’s returns have ranked in the top quartile of all mid-cap ETFs for the three out of the past four full-calendar years. (It lagged its category peers in 2010.) During the first six months of 2014, the Guggenheim fund realized a return of 3.0%, versus the mid-cap category average of 7.5%. Because Guggenheim Spin-Off is not restricted by market-cap size, its returns will differ from “pure” mid-cap funds. The ETF’s expense ratio of 0.65% is above the mid-cap category average of 0.40%.

Caveats & Notes

I had hoped to extend the analysis period from three to five years, but doing so would have resulted in several categories having too few funds. The bond fund categories were particularly problematic in terms of being able to use a five-year period. Among ETFs with at least $400 million in assets under management AUM, only three short-term bond funds, two long-term bond funds and three corporate high-yields have been in existence for more than five years. Several foreign stock ETFs would have also been excluded had a five-year rule been used.

An ETF’s inception date does not tell you whether it is better or worse than another fund. The inception date only reveals how much return data is available to judge the fund’s performance by. Longer periods of return data are preferable because it lessens the impact of one good or bad year. Longer periods can also reveal how an ETF performed during a greater variety of market conditions.

It remains my intention 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 (See “The Top Mutual Funds Over Five Years: Credit the Bull and the Calendar” in the March 2014 AAII Journal). The comparisons will not be completely similar, however, because of the six-month difference in the time periods analyzed. Though seemingly short, the difference can alter 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 overwhelming majority of exchange-traded funds continue to be passively managed. Though the three largest actively managed ETFs do have a significant AUM, more than 70% of all actively managed ETFs had less than $100 million in AUM as of the end of June 30, 2014. Short histories also kept many active ETFs out of consideration, including PIMCO’s Enhanced Short Maturity MINT and PIMCO Total Return BOND. As a result, the only actively managed ETF included in this year’s analysis is AdvisorShares Peritus High Yield HYLD, which launched in November 2010 and had AUM of $1.08 billion as of June 30, 2014.

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 because of their lower costs, transparency and ease of trading. In other cases, active management is better, where a larger amount of choices exists among mutual funds. (See “An Inside Look at Exchange-Traded Funds” in this issue, for more about the similarities and differences between ETFs and 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 $400 million in assets. (Exceptions were made when the performance of a smaller fund warranted it.) ETFs intended 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 shows the top ETFs by category. Three-year performance was calculated through June 30, 2014, to match the statistics displayed in “The Individual Investor’s Guide to Exchange-Traded Funds 2014,” which was published in the August 2014 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, 2014) 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 fund shares have traded at over the period.

The online version of this article, available on AAII.com, contains a list of the 50 top-performing funds, as opposed to the top 10 displayed in the print edition.

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 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.

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