Yes, an actively managed portfolio of exchange-traded funds (ETFs) can generate risk-adjusted excess returns above those of its individual funds-a positive alpha. And, yes, it can be achieved with a wide variety of asset classes, including both large- and small-cap stocks, both growth and value stocks, both domestic and international stocks and both developed and emerging market stocks.

Strictly speaking, efficient markets theory contends that stock price changes follow a random pattern, i.e., subsequent stock price changes can be treated as identically distributed random variables. This theory asserts that everything knowable about a stock is imbedded in its price, and that price changes are due to new information randomly entering the market. Serious followers of business and market cycles, however, recognize that cycles persist for a period of time, that different economic segments benefit to different degrees over the course of a cycle and that segments benefiting the most become more highly valued. While the lengths and amplitudes of cycles cannot be exactly determined, their persistence influences stock prices considerably.

Devising strategies to profit from cyclical opportunities requires that two conditions be met. First, the means to easily implement the strategy must be available; next, it must be tested over a sufficient amount of time to determine its reliability. Fortunately, the first condition is easily satisfied by the use of exchange-traded funds. These are ideal because they are based on indexes representing broad classes of securities because they are broad in variety; and because they are highly liquid, which allows investors to take tactical positions with them.

The second back-testing condition is not as easily met because of the relatively short history of ETFs. If actual ETF performance data are unavailable, it is necessary to substitute the historical performance of the indexes upon which these ETFs are based. Fortunately, this is perfectly acceptable since ETFs track very close to their indexes, and conclusions derived from statistical testing are likely to be valid.

To devise potentially profitable active strategies, it is necessary to recognize when a cyclical change is taking place. This is accomplished by monitoring changes in business and market conditions, looking at changes in fundamental and technical trends, and finding out why one asset class is more likely to be valued over another.

Large- Vs. Small-Cap Stocks

Large-cap stocks are generally characterized as having significant revenues, earnings and dividends; broadly diversified product lines; multiple distribution channels; a large geographical base; substantial financial assets; and liquid reserves. They are usually considered sound investments by investors seeking dividend income, modest capital appreciation and "safe havens" in times of economic stress.

In contrast, small-cap stocks typically have small but significant revenue and earnings potential; meager or nonexistent dividend histories; narrow product lines; limited distribution channels; regional markets; and frequently chronic capital shortages. They are typically considered attractive investments to those who are seeking above-average capital appreciation either through internal growth or acquisitions, things that are most likely to occur during periods of economic expansion.

Given the characteristic differences between large- and small-cap stocks, there are times when large-cap stocks should be owned by investors usually favoring small-cap stocks and vice versa.

For the nearly 20-year period from February 1988 through October 2007, a portfolio that alternated between large- and small-cap stocks whenever one category had greater trailing-two-month returns than the other was more profitable than a simple buy-and-hold strategy in either asset class.             Trailing-two-month returns are used in this strategy to smooth short-term fluctuations and identify the returns' underlying trends.
This strategy produces a compound annual return of 12.5%, which is 0.6% above the Russell 1000 Index's 11.9% and which is 1.3% above the Russell 2000 Index's 11.2% (Figure 1). The strategy has a greater annualized standard deviation, at 15.0%, than the Russell 1000 stocks' 13.6%, but is less volatile than the Russell 2000's 17.5%. The strategy provides a comparable return per unit of risk as measured by its Sharpe ratio, 0.53, which is lower than the Russell 1000's 0.55, but is significantly above the Russell 2000's 0.38.

In one important aspect of risk, downside vulnerability, the strategy's maximum drawdown of 39.8% recovered in 24 months, compared with the Russell 1000's drawdown of 45.1%, which took 49 months (Figure 2). The Russell 2000 had two significant drawdowns over the period, one was 29.8% and recovered in only 16 months and another was 35.1% and recovered in 15 months. The strategy's greater returns account for the shorter recovery period.

The strategy has a significant advantage over simply indexing the Russell 1000 or 2000 over the long run (Figure 3). An initial $1.00 invested in the strategy in February 1988 would have growth to $10.20 by October 31, 2007 while the Russell 1000 would have grown to $9.21 and the Russell 2000 to $8.12.

This strategy is easily implemented using iShares' Russell 1000 Index Fund (IWB) and iShares' Russell 2000 Index Fund (IWM). Both funds have small expense ratios of 0.15% and 0.20%, respectively, and small tracking errors relative to their underlying indexes.

Growth Versus Value Stocks

A similar alpha strategy is possible with growth and value stocks because they, too, have sustained periods of above- and below-average returns. Again, these differences are due to their specific characteristics and the desirability of holding one rather than the other over a cycle.

Growth stocks are typically desired for their above-average earnings growth, high profit margins and superior return on equity. Growth investors expect that a sustained period of above-average earnings growth will afford some protection against price declines, eventually leading to superior capital appreciation.

In contrast, value stocks are usually desired by bargain-hunting investors drawn to inexpensive price-to-earnings and price-to-book multiples; an attractive dividend yield and payout ratio; and an unleveraged capital structure. Such investors believe that if a stock's intrinsic value is sufficiently higher than its market price, it has a margin of protection against severe price declines and yet still offers potential for capital appreciation once other investors discover it is undervalued.

Here again, persistent trends based on business and market cycles can provide profitable opportunities for those using active ETF management. Switching between growth and value stocks whenever one style offers better trailing-two-month returns than the other is a strategy that can achieve better results in the long run than simply buying and holding an investment in either style.

Consider that this strategy correctly selected the group of stocks having superior returns in 128 of the 238 months studied, or 54.2% of the time. From the same 1988 to 2007 time period, the strategy produced a 15.5% annual return, which was 2.8% greater than the Russell 1000 Value Index's 12.7% and 4.8% above the Russell 1000 Growth Index's 10.7% (Figure 1). Although the strategy has a somewhat higher 13.8% annualized standard deviation than the Russell 1000 Value stocks' 12.6%, it has substantially lower volatility than the Russell 1000 Growth stocks' 16.4%. Its Sharpe ratio is 0.80 while the Russell 1000 Value's is 0.64, and the Russell 1000 Growth's is 0.38, and this indicates a superior excess return per unit of risk.

This active growth/value strategy's maximum drawdown of -27.5% is similar to the Russell 1000 Value's -27.7%, and both have an identical recovery period of 15 months. The drawdown is a significant improvement, however, over the Russell 1000 Growth's drawdown of 61.9%, a loss which had not yet been fully recovered by October 31, 2007 (Figure 2).

The significance of these differences is evident in Figure 4. For an initial $1.00 investment on February 29, 1988, the active strategy had a terminal value of $17.06 on October 31, 2007, while the same dollar invested in the Russell 1000 Value strategy had a terminal value of $10.44 and invested in the Russell 1000 Growth strategy had an end value of $7.40. This active growth/value strategy can easily be implemented using iShares' Russell 1000 Growth Index Fund (IWF) and iShares' Russell 1000 Value Index Fund (IWD). Both have small expense ratios of 0.20% and small tracking errors.

Domestic Versus Global Stocks

The recent trend toward globalization has unleashed strong secular and cyclical forces. These can provide opportunities for profitable tactical adjustments in portfolios that hold strategic positions in both U.S. and global investments.

Standard & Poor's 500 Index (S&P 500), arguably the most widely accepted benchmark of large-cap U.S. stocks, is a float-weighted composite of the 500 companies that S&P's Index Selection Committee believes are the leaders in the United States' most important industry sectors. They are not only representative of the domestic U.S. stock market, but they are also a bellwether of the U.S. economy, since the S&P 500 is included in the Index of Leading Economic Indicators. Investors in these large-cap stocks typically seek the same advantages found by investing in the Russell 1000.

Morgan Stanley Capital International's (MSCI's) EAFE Index is the most widely accepted benchmark of foreign stocks in global markets outside North America because of its long history. It represents 85% of the market capitalization of the European, Australasian and Far Eastern stock markets, and it contains stocks from 21 developed markets outside the U.S. and Canada. Investors in EAFE stocks typically seek larger returns through opportunities outside North America.

Like the other strategies we have discussed, a strategy alternating between domestic U.S. and developed global market stocks can produce better risk-adjusted returns than a simple buy-and-hold strategy. Whereas before we used two-month-trailing returns, here we use one-year returns  rebalanced annually (in January) because of the significant volatility between U.S. and developed global markets stocks.

This type of strategy correctly selected the group of stocks having superior returns in 12 of the 18 years studied, or 66.7% of the time. From January 1989 through October 2007, it produced an 11.5% annual return, which was 1.9% greater than the S&P 500 Index's 9.6% and 4.6% above the MSCI EAFE Index's 6.8% (Figure 1). Although it has a somewhat higher 14.2% annual standard deviation than the S&P 500's 13.6%, it has a lower volatility than the MSCI EAFE stocks' 15.9%. It provides superior excess return per unit of risk, as measured by its Sharpe ratio of 0.50. By comparison, the S&P 500's is 0.38 and the MSCI EAFE's 0.15.

This active S&P 500/MSCI EAFE strategy's maximum drawdown, -47.6%, recovers in 30 months. The S&P 500's maximum drawdown of -44.6% is slightly less, but the S&P 500 has yet to reach its prior high as of October 31, 2007. MSCI EAFE's drawdown of 48.0% recovers in 31 months (Figure 2).
The contrasting performances are shown in Figure 5, where the active strategy had a terminal value of $7.72 on October 31, 2007 for every initial $1.00 investment on January 31, 1989. The same investment in the S&P 500 stocks had a terminal value of $5.58 and the MSCI's dollar investment ended with $3.47.

In practice, this active strategy can easily be implemented using the iShares' S&P 500 Index Fund (IVV), which has an expense ratio of 0.09%, and iShares' MSCI EAFE Index Fund (EFA) which has an expense ratio of 0.35%. Both funds have small tracking errors relative to their respective funds.

Developed Versus Emerging Markets
    The economic globalization that has spurred growth in the developed markets has also contributed to the rise of emerging markets. Yet the ebbing and flowing between developed and emerging markets frequently favor one over the other and can lead to profitable tactical opportunities.

MSCI's Emerging Markets Index is the most widely accepted benchmark for gauging the performance of emerging markets because it also has a long history. It is a float-weighted market capitalization index of geographically diverse companies in 26 countries: Argentina, Brazil, Chile, China, Columbia, the Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Malaysia, Mexico, Morocco, Pakistan, Peru, the Philippines, Poland, Russia, South Africa, South Korea, Taiwan, Thailand, Turkey and Venezuela.     Investors in emerging markets stocks typically seek above-average capital appreciation over the long term and are willing to tolerate periods of significant volatility.

Hence, a strategy of alternately investing in developed and emerging markets can provide greater risk-adjusted returns than simply buying and holding those investments. This trend-following strategy invests in the outperforming asset class of last month and stays with or reverses into a profitable trend. Such a strategy correctly selected the group of stocks having superior returns in 138 of the 237 months tested, or 58.2% of the time. It produced a 17.8% annual return, which was 1.4% greater than MSCI's emerging markets' 16.3% and 10.0% higher than the EAFE's 7.8% for the period from January 1988 through October 2007 (Figure 1). Although the strategy has a significantly higher 20.3% annualized standard deviation than EAFE's 15.9%, it has 2.3% lower volatility than emerging markets stocks' standard deviation of 22.6%. Yet it provides superior excess return per unit of risk as measured by its Sharpe ratio of 0.65, compared with the MSCI Emerging Markets' 0.52 and the MSCI EAFE's 0.20.

This strategy's maximum drawdown of -42.4% is recovered in 29 months; MSCI's Emerging Markets' maximum drawdown of -56.0% takes 75 months to recover and MSCI EAFE's drawdown of 48.0% recovers in 31 months.

The significance of these differences is evident in Figure 6, where the strategy had a terminal value of $25.25 on October 31, 2007 for an initial $1.00 investment while MSCI's Emerging Markets' end value was $19.77 and the EAFE index's was $4.37.

This strategy can easily be implemented using iShares' MSCI EAFE Index Fund (EFA), with an expense ratio of 0.35%, and iShares' MSCI Emerging Markets Index Fund (EMM), with an expense ratio of 0.75%. Both funds have small tracking errors relative to their respective funds.

A Caveat On Active ETF Strategies

Historic performances of the strategies discussed are the result of the length and amplitude of the business and market cycles that were encountered. Since the same cycles are unlikely to be repeated in the future, the results of using these strategies may or may not be similar.

Summary And Conclusions

In sum, an actively managed portfolio of ETFs based on popular indexes can produce risk-adjusted excess returns above those of its individual funds-positive alphas above specified benchmarks. This may be accomplished by understanding that business and market cycles persist for a period of time; different market segments benefit differently, and their stocks are valued accordingly. Random relative price fluctuations in these funds may be smoothed by averaging returns over an appropriate period in order to identify a discernable trend. Once identified, the trend can be exploited by acquiring the favored asset and liquidating the other throughout the cycle's duration.