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One ETN Worth Your While

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For the most part, exchange traded notes (ETNs) are better off ignored, but this one is a rare exception to that general principle.

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How CAPE the ETN Works

Even if you're not convinced CAPE (the measure) is not a good gauge of stock market valuations, you can still learn a lot by looking at how CAPE the ETN is constructed. Shiller had a hand in formulating the strategy, and it shows. It's built on sound principles.

The ETN tracks the Shiller Barclays CAPE US Core Sector Index, which every month rotates its exposures to four of the nine S&P 500 Select Sector indexes, the same ones the Select Sector SPDR ETFs track.

The "Relative CAPE Indicator" indicates which sectors to pick. It's based on cyclically adjusted price-to-earnings, or CAPE, which divides real price by average ten-year trailing real earnings.

Because sectors have different earnings characteristics, naively picking the lowest-CAPE sectors would structurally bias the fund to low-growth sectors. In order to get around that, a sector's current CAPE is divided by the trailing 20-year CAPE average to produce the Relative CAPE Indicator. The five sectors most undervalued according to the indicator are chosen. Then, the sector with the lowest 12-month price return is excluded. The remaining four are equally weighted.

The momentum screen is a nice touch. The cheapest sectors are often the most beaten-down, and because momentum is a powerful force in the markets, automatically picking up the cheapest stuff regardless of momentum often exposes you to extra volatility.

While I think the strategy is sensible, keep in mind for most of its back-tested history, which only extends back to late 2002, it kept mostly to five sectors: energy, industrials, consumer staples, health care, and financials. The momentum screen kicked out financials right before the worst of the financial crisis, boosting back-tested returns.

I'm almost somewhat uncomfortable with the short ten-year back-tested history. While I think Shiller has a lot of credibility as a careful economist, I'd feel more at ease if the strategy were shown to work over multiple decades and in foreign countries.

Fees

The ETN levies a 0.45% annual investor charge. Keep in mind that ETNs can pretty much calculate expenses any way they want and bury additional fees in the dense prospectus text. Fortunately, I did not find any idiosyncratic fees or calculations, so you can expect the ETN to lag its target index by 0.45% annually.

Editor's Note: This article was written by Samuel Lee of Morningstar ETFInvestor.

Below, find some more great investing and trading content from MoneyShow:

The Risks and Rewards of ETNs

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Twitter: @TopProsTopPicks
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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