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Buying US growth shares using ETFs

Created:

28 April 2008

Written by:

David Stevenson

Stock screening and exchange-traded funds are part of the investing mainstream in the US, far more so than here. So perhaps it's not surprising that some of the more innovative financial services companies have combined the two to create fundamentals-based ETFs.

In the last few years, dozens of index-tracking ETFs have emerged that track every conceivable style of US investing. And it's spreading over here, with ETF newboy SPA very much leading an increasingly congested pack that includes Powershares and Lyxor. You can now use ETFs to buy everything from value US stocks through to high yielders, and the choice is growing every month.

Three main index providers dominate this growing niche – RAFI (used by both Powershares and Lyxor), Powershares through its Dynamic indexing system and MarketGrader (via SPA). All three index providers and accompanying tracker funds share many similar characteristics - they all, to varying degrees, use fundamental measures, and they're all cheap compared to their active fund siblings.

Most of the ETFs charge between 0.6% and 0.9% per annum with no initial charge (although you might have a spread on the bid-offer price) while most of the unit trust providers charge 5% as an initial charge and at the very least 1.5% per annum as an annual management charge. ETFs also give you greater flexibility to switch between styles and sectors.

Before you even think about investing in an fundamentals-based index tracking fund, you need to understand the kind of shares you're buying into and the methodology used by the index provider. Both RAFI and Powershares have kept the magic ingredients that go into their indices secret. We know that they mix up earnings and sales growth alongside intrinsic value and technical strength, but we don't know how these criteria are weighted.

MarketGrader is more open about the way its screens the market. It fully discloses all the fundamental measures used, ranging from market share based measures and asset utilisation through to cashflow and the PE ratio. MarketGrader also has a US web site for private investors where you can even use this stock screening methodology to look at individual shares (provided you take out a subscription). The only secret bit is the way in which the company precisely mixes and matches these measures on a quarterly basis. Leading US investor newspaper Barrons also uses the MarketGrader methodology to construct its own index.

MarketGrader index structure is used by the SPA funds, which I also rate in terms of returns and the kind of shares they tend to focus in on. The table shows recent returns from a range of actively managed unit trusts alongside SPA and the other US fundamental indexers. We think the message is clear: over this short period, the SPA funds have performed consistently better than their rivals with less volatility and at lower cost. Of course, 'past performance is not always a guide to the future', but back-testing of the funds has showed outperformance against the S&P 500.

The SPA/MarketGrader funds tend to hone in on mid-sized, fast growing companies whose share price is not expensive given their growth prospects and market position. It's what we would call 'growth at a reasonable price' methodology. It's the perfect way to own high-growth shares in an overseas market - without the effort of having to screen that market yourself.

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