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How to Pick ETFs

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Investors can choose an ETF based on asset class exposure, or a particular ETF's methodology or construction.

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There are several ways to choose ETFs for asset class exposure. All asset managers have their own way to select the asset classes in which they want exposure; once they determine that, they also have ways to determine which stocks or ETFs to use for the exposure. You can do the same thing.

Another way you can choose to buy an ETF (or a number of them) is based on whether or not you like an ETF's methodology, its construction, and the reasoning behind why the ETF uses the stocks it does for its index. You can make ETF picking as personal as you want by simply buying the ETFs that you like.

Much as we might try to break down investing as a formulaic endeavor, investing is not a dispassionate or totally rational exercise. When investing, a person can use his or her intuition and personal proclivity toward securities, index construction, and desire for certain asset classes in investment decisions.

An ETF to Buy Because of Quantitative Construction
There have been few ETFs linked to quantitative indexes in the past, but the number of these ETFs has been growing steadily.

PowerShares was one of the first ETF makers to come out with alpha-seeking ETFs, and it continues to develop new securities. The PowerShares Dynamic MagniQuant ETF (NYSEARCA:PIQ) tracks the Dynamic Top 200 Intellidex Index (INDEXNYSEGIS:DYHTR). The index is constructed to identify 200 stocks with the greatest capital appreciation potential. The Intellidex method evaluates the investment merit of the 2,000 largest domestic companies and analyzes the companies' merits from five broad financial perspectives: price momentum, earnings momentum, quality, management action, and value.

PowerShares does not sort the stocks it uses for PIQ by sector, industry, style, or market cap, so it is not limited to any one asset class. It is also not required to provide diversification. PIQ is constructed to seek alpha through stock selection, style, or any other factors it deems appropriate for its model.

PowerShares uses its "Dynamic" stock selection in other ETFs, but PIQ is the only ETF that is free to use this stock selection process free of asset class restrictions. PIQ holds a mix of large, medium, and small cap firms. Adding to its appeal is the fact that about 47% of its stocks are small cap. Consumer discretionary comprises about 21% of the index; financials, 19%; and technology, 14%.

Over the past last year, and in shorter time spans, PIQ has handily outperformed the S&P 500 Index (INDEXSP:.INX).

ETFs to Buy for Asset Class Exposure

Another way to buy ETFs is to consider which asset class will perform, and to buy an ETF or ETFs to fill that desired class. Emerging markets are expected to perform well the second half of the year. Emerging markets (or EM) have not performed over the last year, and they are being panned by some investors and pundits. Many that praised the group when it was hot are now saying that emerging markets' success might only be marketing hype, and the group should be avoided.

But it depends on your perspective. Over the last year, EM, using the iShares Emerging Markets ETF (NYSEARCA:EEM), have not performed. Over the last five years, they have not performed. But over the last ten years, EEM has beaten the S&P 500 handily. WisdomTree says that 2012 was a high dividend year for EM. After a high dividend year, the next year is usually an outperforming year. If this follows, 2013 will be a good year.

So you should consider buying EM, and then find an EM ETF that you like for asset class exposure. One that should be considered is the WisdomTree Dividend Weighted Emerging Markets ETF (NYSEARCA:DEM). DEM has recently rebalanced its portfolio, and the largest change was to increase its exposure to Russia. Russia now comprises about 13% of DEM, the other large constituents being Taiwan at 20%, and China at 16%. This represents a rather large overweighting of Russia compared to EEM, which has about 6% of Russia in its portfolio. Investing in Russia has risks, and its claim of being a fast-growing emerging market country has its skeptics. Although risky, Russia is trading at a low valuation. The MSCI Russia Index is trading at about five times earnings, and its five-year average price earnings multiple is about seven times.

There are some positives regarding DEM. Taiwan has recently had its 2013 GDP growth estimate increased, and fears of a China slowdown seems to be abating. The index that DEM is constructed to replicate has a multiple of about 11 times earnings, and pays a dividend of 5.73%. Fees and expenses will lower the dividend of DEM, however.

Another ETF that will get you representation in EM while also getting exposure to companies in the developed countries of Europe is the RevenueShares ADR Fund ETF (NYSEARCA:RTR). The portfolio contains stocks in Europe, which have underperformed on a longer-term basis, but have been performing lately. RTR sells about ten times earnings, which is a reasonable multiple, and pays a dividend of about 2.3%. RTR has an interesting mix of stocks in growth areas and developed areas, with a weighting of 25% United Kingdom, 13% Japan, 12% China, and 9% Canada. Japan has been a laggard for years and is favored by many money managers to be a good performer in 2013.

RTR has a heavy weighting in energy and financial services, with these sectors comprising over 56% of the ETF. The sectors have the heavy representation because sales are high in the companies that are in these sectors. In the revenue weighting format that RTR follows, high sales should later translate into higher earnings, and higher earnings should excite investors enough to increase the stock prices of these companies.

Editor's Note: Max Isaacman is the author of Blizzard of Money, Winning with ETF Strategies, Investing with Intelligent ETFs, How to Be an Index Investor, and The NASDAQ Investor.
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At the time of this article, Isaacman and/or clients may own shares of RTR, PIQ, EEM, and DEM.
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