"I've heard that there are more ETFs in registration now than there are ETFs on the market, and I believe it," says David Cohen, managing director of product development at Claymore Securities in Lisle, Ill. And well he should. ETFs are rolling off the line faster than mutual funds in the 1980s and 1990s. Morgan Stanley recently reported that 354 exchange-traded funds (ETFs) held more than $400 billion in assets. In other words, the number of ETFs have tripled in the past four years, and the assets in those funds have quadrupled (see "On the March," below).

New flavors are coming out all the time. Leading product maker Barclays Global Investors just launched eight fixed-income ETFs. Rival State Street Global Advisors just introduced streetTRACKs Dow Jones Wilshire International Real Estate. Vanguard is filing for four bond ETFs that will be share classes of existing mutual funds. Smaller firms are bringing out leveraged ETFs. As investors pile in, supply is surging.

The panoply of new products seems just as welcome to financial advisors. According to a recent survey conducted with Financial Planning, Rydex Investments in Rockville, Md., found that 64% planners think that the existing ETF lineup provides "a good range of options" or that "more are needed." Only 16% think there are "far too many" ETFs on the market. In a January Financial Planning poll, 58% of advisors named ETFs as the product they plan to use more often in 2007, far ahead of second-place annuities (16%). Expanding the ETF menu, it seems, has whetted planners' appetites.

It's easy to see why. ETFs offer tax-efficiency, transparency, instant execution and lower management costs than most mutual funds. On the tax front, ETF investors don't have to take a capital gains distribution at the end of the year as they would with a mutual fund. They only have tax liability when they sell the ETF.

ETFs are transparent because they are based on established indexes and are essentially passively managed--although some may make regular rules-based changes. So investors know exactly what exposure they're getting. And most ETFs charge 70 basis points or less in management fees. Finally, since ETFs trade on exchanges, positions can be quickly hedged, bought or sold. However, trading commissions can easily overwhelm the cheaper management cost of ETFs.

AND NOW, "SPINDEXES"

Most of these ETFs have been used as cheaper substitutes for index funds, to gain broad market exposure at a cheaper price. Asset manager Rick Ferri, CEO of Portfolio Solutions in Troy, Mich. invests client assets in portfolios composed strictly of ETFs, a strategy more advisors may follow. "The big advantage comes from operational efficiency," he says. "You can trade throughout the day and know what you're buying or selling."

But along with the proliferation of ETFs has come not only finer and more exotic slices of markets, such as Wheaton, Ill.-based PowerShares' clean energy, water, nanotech and currency ETFs, but also a plethora of managed ETFs--or what Ferri calls "spindexes." These ETFs often promise superior returns at lower risk and cost. And they may offer mass affluent clients sophisticated strategies formerly available only through institutional managers.

A few notable entries have posted admirable three-year records. PowerShares' Dynamic Market and Dynamic OTC Portfolios, both started in mid-2003, had annualized returns of 14.60% and 9.55%, respectively, from 2004 through 2006, according to Lipper. That topped the 10.32% and 6.21% annualized returns of the more established SPDR (which tracks the S&P 500) and QQQ (Nasdaq 100) during those years. PowerShares ETFs basically mimic the composition of these indexes, but Powershares ranks stocks by 25 factors and uses the rankings to determine which stocks to select. These are essentially quant funds where stocks are picked and rebalanced within a proprietary rules-based system.

Although some call these newer designer products managed ETFs, they are not truly managed in the sense of an experienced stock-picker using a combination of intuition and experience to buy and sell. It would be very difficult actually to create a managed ETF because it would expose the manager's strategy, says Steve Sachs, director of trading at Rydex Investments. "Managed ETFs are all based on some set of rules, more like enhanced index funds," he explains.

FUNDAMENTALLY SPEAKING

Of all the newfangled ETFs, Powershares' FTSE RAFI US 1000 has attracted the most interest. The fund follows a fundamental, rather than capitalization-weighted, domestic large-cap index, says Bobby Brooks, vice president and national sales manager for PowerShares. "In this ETF, a company's weighting is determined by sales, cash flow, book value and dividends, which provide a truer barometer of its economic impact. Fundamental indexing generates a better benchmark."

The FTSE RAFI US 1000 was launched in late 2005 and designed by Rob Arnott, chairman of Research Affiliates, an investment research consultant in Pasadena, Calif. At the time, he predicted that the ETF would outperform cap-weighted indexes by about 2% a year. In its first year, the FTSE RAFI delivered a 17.51% return in 2006, compared with 15.79% for the S&P 500 and 15.69% for the SPDR ETF, according to Lipper. Small- and mid-cap versions of the index appeared in 2006, while international entries may be introduced this year.

Does this outperformance stem merely from launching into the right market? Maybe. When an index departs from cap-weighting, the result probably will be a tilt to value and small-cap stocks--which have led the market lately. "Many of the newer ETFs have a value bias, which raises a valid philosophical question," says Dan Culloton, a senior analyst at Morningstar. "Are they really index funds, or just a form of value investing?" But others argue that they offer a preferable alternative to the growthy bias of cap-weighting. Arnott stresses that because cap-weighted indexes are driven by a company's market value alone, investors are often forced to buy into market bubbles.

The initial outperformance of a few constructed ETFs is hardly enough to convince the doubters. "We use ETFs extensively, but not because we expect them to deliver a better return," Ferri says. "The only return advantage results from low cost." He points out that the "spindexes" have annual expense ratios upward of 60 basis points (0.60%), while the ETFs he uses, such as Vanguard's large-cap VIPER, charge 20 bp or less.

Regardless of the true merits of fundamental indexes, other companies are launching products based on fundamental factors. "An ETF is better tethered to a fundamental index, rather than a cap-weighted index," says Bruce Lavine, CEO of WisdomTree Investments in New York. All of WisdomTree's ETFs track indexes in which companies are weighted by the absolute dollars they pay out in dividends. Again, focusing on dividend payers would seem to produce a value-heavy ETF, but Lavine thinks that's an oversimplification. "Our ETFs may tilt toward value, but they include some companies that are considered growth stocks," he says. "The definition of value and growth can shift around, but our method of using dividends is consistent. We're not trying to force companies into one category or the other."

Rydex has developed ETFs based on the value-growth debate. From the S&P 500, Rydex carves out "pure value," "pure growth" and equal-weight offerings. "They complement cap-weighted funds nicely," says Tim Meyer, Rydex's ETF business manager.

Rydex has also introduced currency ETFs, which may become more popular if the dollar continues to drop and investors become more international in their outlook. The ETFs are structured as grantor trusts so any gains are taxed as ordinary income, which would increase the tax bite on long-term holders. Nevertheless, Meyer asserts that they are "better mousetraps" for investors who want a simple way to participate in currency moves.

LEVERAGED STRATEGIES

Some new ETFs are packaging sophisticated institutional investing strategies so they are easier for advisors to use with high-net-worth clients, or even with mass-affluent clients. ProShare Advisors in Bethesda, Md., has created ETFs that start with familiar indexes such as the S&P 500 and the Nasdaq 100. "But they allow investors to magnify their exposure to the market by using leverage or going short," says CEO Michael Sapir. The leverage or shorting is built into the ETF so an investor doesn't have to set up a margin account to implement the strategy.

For example, ProShare's UltraShort QQQ is designed to produce twice the opposite performance of the Nasdaq 100. A 10% index gain is a 20% ETF loss, and vice versa. "Many advisors are using the short ETFs to hedge portfolios," he says. On the long side, advisors may be using leveraged ProShares to increase exposure to equities and thus free up funds to go elsewhere, perhaps into cash.

Claymore Securities offers a variety of specialized ETFs that "offer rational applications that can add value for investors," says CEO Cohen. "We have a BRIC [Brazil-Russia-India-China] ETF as well as a sector rotation ETF." Claymore Sector Rotation ETF tracks an index developed by Zacks Investment Research. Zacks divides the stock market into 16 sectors, from aerospace to technology. Using a model, it underweights sectors (as low as 0% of the index) or overweights them (up to 45%) based on the market outlook. Once the sector weights are determined, companies are chosen based on liquidity and market cap. Each quarter, the index is rebalanced and stocks are bought or sold to reflect new sector weightings.

Another Claymore offering is the Zacks Yield Hog ETF, "which has been very popular because of its potential for high distributions," according to Cohen. "Half the portfolio is invested in high-yield domestic stocks while the other half is spread among ADRs, REITs, MLPs, closed-end funds and preferred stocks."

Perhaps most novel is Claymore's linked pair of ETFs, which allow investors to choose either the bull or the bear side in a pure oil play. MacroShares Oil Up and Oil Down ETFs were introduced in late 2006, providing exposure to energy price moves without involving futures contracts, company fundamentals or exotic debt. If oil shares move up, the Up ETF rises in price, the Down ETF drops, and vice versa. The money raised in the offerings is held in Treasuries, which are passed back and forth between the two ETFs as oil prices fluctuate. Other Up or Down vehicles are in the hopper.

Barely three weeks into 2007, another new entrant, XShares Advisors in New York, introduced yet another new type of ETF called "vertical" funds. These focus on healthcare stocks, but also on narrow subsegments of healthcare, such as cardiac devices and emerging cancer treatments. "Each of our ETFs provides a way to participate in long-term secular trends as medical needs increase," says Bill Kridel, co-founder of XShares.

These ETFs also have a unique weighting method. Other healthcare mutual funds and ETFs may hold hundreds of stocks, but are heavily weighted toward the top 10. By contrast, most HealthShares will hold 22 to 25 stocks, without dominant weightings in one or two mega-caps. "Our companies are in the fat middle of the market, where there is high growth, high innovation and a high likelihood of being bought out," Kridel says.

With this surge of creativity in the ETF market, there's a good likelihood that packaged products will soon be offered to financial planners. New Yorkbased XTF already has four different types of ETF portfolios on the market: tactical (conservative to aggressive), target date, country and sector rotation. For example, one portfolio equally weights 13 developed foreign countries and periodically shifts between each country's index ETF and an intermediate U.S. Treasury. If, for example, the model shows that a country's index will outperform the yield on the Treasury, the portfolio buys that country's index ETF. If not, it sells the ETF and buys Treasuries.

"We have been offering separately managed accounts for these portfolios, with a $50,000 minimum investment," says Michael Woods, CEO of XTF. "In 2007, we plan to offer our ETF portfolios through mutual fund companies, 401(k) plans, variable annuities and variable universal life insurance policies."

PLANNER REPORTS

Planners are finding interesting new ways to use ETFs to add alpha to portfolios, or at least minimize risk. Tony Welch, co-founder of Capital Strategies in Sarasota, Fla., uses Powershares ETFs to minimize company-specific risk. Take PowerShares Dynamic Semiconductor Portfolio, for example. "Old-style semiconductor indexes may include a lot of Intel, but it seems like that stock is always blowing up," Welch says. "With the filters used by PowerShares, there is no Intel in its ETF, which removes that single-company risk." Welch also uses the PowerShares retail ETF, which has no Wal-Mart or Home Depot, "two stocks that have been underperformers for years." Welch has also used some of WisdomTree's international sector ETFs, including its basic materials fund to avoid Alcoa. "It is a big holding in most basic materials funds, but has been a big disappointment," he says.

Welch also uses an even more sophisticated offering from PowerShares, its DB G10 Currency Harvest ETF, which follows a currencies-linked-to-interest-rates strategy developed by Deutsche Bank. The ETF buys currencies of countries with high interest rates at the same time as it shorts currencies with low rates. "It's a complete diversifier, with no correlation to anything, including the U.S. stock market," says Welch. "We give it a 5% allocation in clients' portfolios and it has worked very well. Before, you needed to trade on an exchange if you wanted to implement this strategy, but now you can just buy the ETF."

Another planner who has begun using some nontraditional ETFs is Bill Kieffer of the Goodson, Kieffer & Carter Asset Management Group of Wachovia Securities, in Evansville, Ind. "In the past, when we added an asset class to our models, we typically would get a slight drop in expected return," he says. "We also could get a substantial drop in standard deviation so our risk-adjusted return would improve." When Kieffer introduced WisdomTree ETFs to the equation, he says, "our models' expected returns went up substantially." His colleague Otis Carter describes the firm's conservative growth portfolio as an example. "We now have 26 holdings in that portfolio, most of which are ETFs," he says. "That includes eight ETFs from WisdomTree, which make up over half the portfolio." Of those, top weightings are in the Europe Small Cap Dividend (11.58%), High-Yielding Equity (9.69%) and Small Cap Dividend (9.04%). "We're extremely pleased with these new products so far," says Carter. "They help us deliver institutional-quality portfolios to retail clients."

Planner Tom Lydon, president of Global Trends Investment in Newport Beach, Calif., uses ETFs for clients' portfolios and runs etftrends.com, a website specializing in ETF news and commentary. He notes that WisdomTree's International Communications Sector Fund "owns the space" because there is no other international communications or telecom ETF. Domestic opportunities for telecom might be limited, according to Lydon, but the growth potential in emerging markets is striking.

Undoubtedly, financial giants and ambitious start-ups will race to introduce newer and better ETFs. Some might be nothing more than marketing hype, while others appear truly to add value. "Advisors owe it to their clients to take at look at nontraditional ETFs," Welch says. "The ultimate decisions can then be made with your eyes wide open."

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