5 Super ETFs

If you're trying to edge the overall stock market, you can take your chances by picking individual issues, or you could buy an actively managed mutual fund. But some exchange-traded funds may get the job done, too, and it won't cost you much to give them a shot.

ETFs are like mutual funds, but they trade like stocks. The biggest and cheapest ETFs mirror major benchmarks, such as Standard & Poor's 500-stock index. Annual fees for many ETFs are extraordinarily low--as little as 3 cents per year for every $100 invested.

Yet you don't need to pay much more for ETFs that aim to beat the major bogeys. Such ETFs hold baskets of stocks that often look very different from the S&P 500. Some of these funds focus on shares of undervalued small companies. Others tilt toward stocks with upward share-price momentum, or companies with high-quality balance sheets. You can also buy "low volatility" ETFs that should hold up relatively well in a market downturn.

The common theme with these funds is that they emphasize stocks with attributes such as value, momentum or quality. Many studies have found that stocks with one or more of these "factors" tend to produce superior long-term results compared with the market averages. These types of stocks may deliver only an extra percentage point or so of gains per year. But that adds up if you stash them away for a decade or more.

Markets tend to favor one style or strategy for long periods, so don't expect these funds to excel under all conditions. Value stocks, for instance, have trailed growth stocks over the past decade. Small-capitalization stocks, which beat large caps for much of the 20th century, haven't lived up to their reputation as giant slayers for the past 15 years. "It takes a long time for a factor to work, and most investors don't have the patience to stick with it through the bad times," says Wesley Gray, a former finance professor who now heads Alpha Architect, an ETF sponsor and investing firm.

Below are five ETFs that we like for their potential to surpass the major indexes. Some will thrive in strong bull markets; others should excel in downturns. For investors who don't want to make timing wagers, we also profile an ETF that wraps several strategic bets in one package. The amount you should invest in each fund depends on your appetite for risk. Remember, too, that patience is key: You may have to hold these ETFs for years to reap their rewards. (Prices and returns are as of June 30, unless otherwise noted. For comparison's sake, the S&P 500 returned 17.9% over the past year and 9.6% annualized over the past three. Funds are listed in alphabetical order.)

Goldman Sachs ActiveBeta Large-Cap Equity
(symbol GSLC, $48)
Assets: $2.2 billion
Expense ratio: 0.09%
1-year return: 15.4%
Top three holdings: Apple, Microsoft, Johnson & Johnson

One of the big challenges with strategic ETFs is getting the timing right. Predicting whether a momentum strategy will take the lead over one that focuses on value stocks or high-quality firms isn't easy. And it's tough to say when stocks will hit the skids and stay depressed, making low-volatility stocks the best bet.

Run by the money-management division at Goldman Sachs, this ETF combines four strategies in one package. Goldman ranks stocks in the S&P 500 by their momentum, quality, value and volatility. Stocks that screen well on these measures carry more weight in the fund, with each strategy accounting for 25% of assets. The results should be smoother returns than any one factor is likely to produce on its own, says Goldman.

Ultimately, the ETF, which launched in September 2015, may help you get an edge, partly because you won't have to time your bets. Many studies find that investors miss out on gains because of bad timing (buying stocks after their prices have run up and avoiding them after they have declined). This ETF takes the guesswork out of the process. And the fund won't cost you much, with a razor-thin expense ratio.

Granted, this fund isn't likely to surge ahead of the market. In one way its roster of 450 stocks resembles the S&P 500, emphasizing giants such as Apple and Microsoft. The fund does grant midsize firms a bit more clout than an S&P 500 fund does, giving it an edge if smaller companies vault over the mega caps. The ETF also looks slightly cheaper than the S&P 500 based on measures such as price-to-sales and price-to-cash-flow ratios (though its overall price-earnings ratio is about the same as the S&P's). Overall, the fund probably won't deviate sharply from the market, says Gray, who is not affiliated with Goldman Sachs.

Nonetheless, if you don't want to place your own strategic bets, this ETF should give you a small advantage over a traditional S&P 500 fund. The fund's low fees--barely more than what the cheapest S&P 500 ETFs cost--should help, too.

iShares Edge MSCI Minimum Volatility USA (USMV, $49)
Assets: $13.7 billion
Expense ratio: 0.15%
1-year return: 8.2%
3-year annualized return: 11.8%
Top three holdings: Becton Dickinson, Johnson & Johnson, McDonald's

The more risk you take, the more money you make. That's a basic principle of financial theory. But it may not be so ironclad. Companies with relatively stable share prices tend to beat the market over the long term, mainly by managing to hold up better in downturns.

Researchers call this an investing anomaly or paradox because the effect shouldn't exist once everyone discovers it (quickly wiping out the advantage). Yet it appears to persist for the same reasons that value and momentum investing keep working. Irrational as it may be, investors love risky stocks and tend to "overlook their stodgier counterparts," says investing firm AllianceBernstein. Active fund managers often shun the tortoises, too, concentrating on faster-moving stocks to try to boost their returns.

This ETF aims to exploit the paradox by tilting toward less-volatile, large-cap U.S. stocks. Health care companies and consumer products businesses prevail in the lineup, led by firms such as Becton Dickinson, Johnson & Johnson and Pepsico. Overall, the fund has been 16% less volatile than the S&P 500 over the past three years. Yet it has outpaced the index by an average of 2.2 percentage points per year.

This ETF usually won't beat the market in a rally that favors more growth-oriented companies. And if you buy now, you'll pay a steep price for safety. Stocks in its portfolio trade at nearly 23 times estimated earnings, compared with 18 for the S&P 500. Nonetheless, the fund should hold up relatively well in a downturn. These steady Eddies "won't soar as high in bull markets," says AllianceBernstein, "but they generally won't fall as much in crashes and, thus, have less to make back when the market recovers."

iShares Edge MSCI USA Momentum Factor (MTUM, $89)
Assets: $3.1 billion
Expense ratio: 0.15%
1-year return: 18.0%
3-year annualized return: 13.4%
Top three holdings: JPMorgan Chase, Bank of America, Microsoft

Buying this ETF is like hopping aboard a fast-moving train. The fund emphasizes companies with rapidly rising share prices. Stocks on the upswing usually remain on that path for long periods, and this ETF aims to harness that effect.

Technology stocks, which account for about 30% of this ETF's assets, have been especially strong in recent years. Top holdings include Apple, Microsoft and chipmaker Nvidia. Banks and health care stocks are also exhibiting good momentum these days, putting stocks such as JPMorgan Chase and UnitedHealth near the top of the fund's lineup.

A stock's momentum can fade as investors rotate into more-promising areas. This ETF adjusts its holdings twice a year to try to capture these swings. But it's an imperfect solution, and as a result, the ETF will occasionally lag the broad market. Moreover, because of the ETF's relatively static nature, it may not adjust its holdings fast enough after a bear market ends to fully participate in the early stages of a recovery, says Morningstar's Alex Bryan.

Nonetheless, the ETF's strategy does appear to work over the long term. Researchers have found evidence of the momentum effect in markets around the world, across multiple time frames. One reason for momentum's persistence is that investors tend to stick with the same winning stocks, even if they get pricey. Whatever the explanation, momentum is a factor that every investor should include in his or her portfolio, says Clifford Asness, cofounder of investing firm AQR Capital Management, which specializes in alternative strategies.

iShares Edge MSCI USA Quality Factor (QUAL, $74)
Assets: $3.7 billion
Expense ratio: 0.15%
1-year return: 14.9%
3-year annualized return: 10.5%
Top three holdings: Altria, Johnson & Johnson, Microsoft

Companies with strong profitability, clean balance sheets and steady profits tend to thrive in the long run. That's the thinking behind this ETF, which tilts toward large, "quality" U.S. firms. Tech, health care and financial services dominate the roster, led by the likes of Apple, J&J and Visa. What you won't get are many producers of raw materials, which are sensitive to economic cycles and tend to deliver inconsistent earnings, and utilities, which have relatively low profitability.

Quality doesn't come cheap these days, though. The P/E of the ETF's portfolio is slightly higher than that of the S&P 500. The ETF also looks expensive on measures such as cash flow, sales and book value (assets minus liabilities). Because of its relatively lofty valuation, the ETF may have trouble beating the market in the near term. Quality can also be a drawback when investors favor more economically sensitive, lower-grade stocks.

But the ETF's long-term prospects look solid. The fund tilts toward companies with well-entrenched advantages--those with hefty financial muscle and the capability to fend off competitors over the long run. Market slumps shouldn't drag these companies down as much as riskier businesses. Some studies have found that high-quality stocks tend to beat the broad market, too, making this ETF a reasonable long-term bet.

Vanguard Russell 2000 Value (VTWV, $104)
Assets: $167 million
Expense ratio: 0.2%
1-year return: 25.3%
3-year annualized return: 6.9%
Top three holdings: XPO Logistics, Olin, New Residential Investment (as of May 31)

Small-company stocks aren't for everyone. Small caps tend to bounce around more than the shares of large companies, making them susceptible to steeper losses in a market slump.

The trade-off is that small caps can deliver fine results, especially if you buy the cheap ones, which this ETF emphasizes. "The payoff of owning value stocks rises as you go down the market-cap spectrum," says Ben Johnson, Morningstar's chief of ETF research.

As of May 31, the fund held 1,358 stocks with an average market value of $1.6 billion (tiny compared with the $88.3 billion average in the S&P 500), according to Morningstar. Banks and other financial firms, industrial companies, and real estate businesses dominate the roster. In general, these aren't fast-growing companies, but you won't pay much to own them. Stocks in this ETF trade at 1.4 times book value, compared with 2.2 for the Russell 2000 index, which tracks small-cap stocks. The ETF looks inexpensive on other measures, too, such as price-to-sales and price-earnings ratios.

A thin expense ratio should help the fund beat costlier actively managed funds, as well as most other ETFs in this space. The fund also holds a larger collection of stocks than ETFs that track the more concentrated S&P 600, another popular small-cap index. That should provide greater exposure to the small-cap value effect, says Gray.

We swap two funds in the ETF 20

We're making a couple of changes in the Kiplinger ETF 20, the list of our favorite exchange-traded funds. Specifically, we're adding two of the funds here. Why not all five? To add all of them, we would have to remove five ETFs from the existing roster, and, in truth, we're comfortable with almost all of them. Still, we expect the five ETFs we're featuring in this article to be winners.

First up, we're replacing iShares Core S&P Small Cap (symbol IJR) with Vanguard Russell 2000 Value (VTWV). The Vanguard ETF trailed the Russell 2000 index, which tracks small-company stocks, by an average of 0.5 percentage point over the past half-decade. But the Vanguard fund burst ahead by 10 points in 2016, and we think it stands a good chance of continuing its hot streak. Although value stocks are always, by definition, cheaper than growth stocks, the valuation gap between the two is among the largest it has been since 1942. Value stocks tend to beat growth stocks when they are this cheap, making this ETF more compelling than a broad small-cap fund.

After a big run-up, tech stocks could be due for a breather. So we are replacing Vanguard Information Technology (VGT) with iShares Edge MSCI USA Momentum Factor (MTUM). You'll still get a big slug of tech in the fund. But it holds an array of other stocks with good price momentum. If tech keeps surging, the iShares ETF will benefit. But the fund won't lose as much as a pure tech ETF if the sector fizzles out.

Daren Fonda is an associate editor at Kiplinger.