ETF Strategies That Topped Benchmarks

NEW YORK ( TheStreet) -- Developers of exchange-traded funds comb through academic research, seeking strategies that have delivered outsized returns.

Popular ETFs with academic pedigrees focus on stocks with high dividends and low volatility. Not all the strategies have succeeded. What worked in the past does not necessarily succeed in the future. But a handful of ETF strategies have compiled compelling five-year records, topping the S&P 500 by more than 5 percentage points.

Among the winners are First Trust US IPO Index (FPX), Guggenheim Spin-Off (CSD) and PowerShares Buyback Achievers (PKW). Can these ETFs continue outperforming? Probably.

The strategies are all based on well-documented anomalies that have persisted for years. But it seems unlikely that the ETFs will top the benchmarks by such wide margins in the future. As money managers notice the successes, more competitors are likely to appear and bid up the prices of target stocks.

Among the strongest performers is First Trust US IPO. During the past five years, the ETF returned 32.1% annually, compared with 25.8% for the S&P 500, according to Morningstar. The ETF outperformed the S&P 500 in each of the past five years.

First Trust IPO aims to exploit the mixed patterns of initial public offerings. As investors discovered during the Internet bubble of the late 1990s, many IPOs become excessively hyped, surging on their first trading days and then languishing. But some IPOs prove to be terrific investments, says Josef Schuster, who designed the index that the ETF tracks.

In his research, Schuster found that most IPOs suffered double-digit losses in their first four years of trading. But the top 25% of new companies recorded big gains, as the best young companies won favor on Wall Street by delivering strong earnings. When all the winners and losers were lumped together, the average result surpassed the market by a wide margin.

To improve its odds of success, Schuster's benchmark takes only the 100 largest IPOs that started trading in the past four years. That eliminates some small shaky deals that may never succeed.

In addition, the benchmark excludes stocks that showed peculiar patterns in their first few days of trading. Say a stock doubles on its first trading day. The IPO would be left out of the index because such skyrocketing stocks tend to sink in later weeks.

The ETF had particularly strong performance in the past 12 months, returning 41.9% and topping the S&P 500 by 16 percentage points. Holdings that soared in the past year include Facebook (FB) and Tesla Motors (TSLA).

The recent returns may have been unusually high because of peculiar conditions in the financial markets, says Ryan Issakainen, ETF strategist for First Trust. In the years after markets collapsed in 2008, few IPOs appeared. Investors were too nervous to bet on new companies. Most of the IPOs that did make it to market were for companies that had solid balance sheets.

"Since the financial crisis, the IPOs tended to be very strong companies that have gone on to do well," Issakainen says.

Some investors have long favored companies that are buying back their stock. When a company repurchases stock, the total number of shares is reduced, so that earnings per remaining share can increase. That tends to prop up share prices.

Besides delivering outsized returns, buyback stocks can be relatively stable. The strategy has enabled PowerShares Buyback Achievers to return 28.1% annually during the past five years.

Holdings in the buyback ETF include reliable cash generators, such as software giant Oracle (ORCL) and defense contractor Northrop Grumman (NOC). "Companies that have the cash to do buybacks tend to have healthy balance sheets and be confident about their future," says Joe Becker, product strategist at Invesco PowerShares.

Ford Equity Research, which designed the benchmark used by PowerShares, includes only companies that bought back 5% or more of their stock in the preceding 12 months. While all companies that do buybacks tend to excel, those that make the biggest buybacks have delivered outsized returns.

Investors have long known that spinoffs can outperform. These occur when a company with several divisions decides that its stock is undervalued. To boost prices, management transforms one of the divisions into a standalone subsidiary and distributes stock in the unit to existing shareholders.

When the spinoffs first begin trading as public companies, they often sink as shareholders dump the little-known stocks. Gradually the spinoffs revive and thrive. In some cases, new managements excel because they are no longer shackled by corporate bureaucracies that may not have focused on a minor division.

During the past five years, Guggenheim Spin-Off returned 35.2% annually. The fund includes companies that have been spun off in the past 30 months. The portfolio holds 33 stocks, including Kraft Foods (KRFT) and online travel company TripAdvisor (TRIP).

At the time of publication, the author had no position in any of the stocks or funds mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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