If last year was the coming out party for bond exchange-traded funds (ETFs), then 2008 is lining up as the "Year of the Quant Stock ETF."

After years of anticipation, three prospectuses for active equities ETFs were filed in the second half of 2007. In addition, a majority of the 451 ETFs and exchange-traded notes (ETNs) currently on file with the Securities and Exchange Commission (SEC) involve some form of quantitative or alternative methodology to index construction.

It's a wave that's sure to transform a $572 billion industry which has been growing by leaps and bounds, spurred by a more flexible trading platform than traditional index mutual funds.

Last year was no exception. Rising volatility in almost every stock sector and a spreading meltdown in credit markets made analysis of ETFs along broad style categories difficult. But if one generalization rings true, it's that growth of any market-cap size did better than value-oriented funds.

A closer look at individual ETF results, however, shows that 2007 was a relatively strong year for more plain-vanilla quant funds. Others, trying to be more exotic in theme and screening methods, tended to find a rougher go of it. In many cases, quant funds pushing the envelope by so-called "investing between indexes," fell badly behind the broader market.

The Blue Chip Leaders

Take large-cap core styles, the most scrutinized and liquid part of the U.S. stock market.

Top gains were turned in by the Claymore/Ocean Tomo Patent ETF (AMEX: OTP). It returned 17.4% in 2007 by implementing a quant process that screens for companies showing histories of holding "high-quality patents." The top 300 are then weighted in the portfolio according to market-cap size.

OTP held less than 1% of its assets in Financials, which were rocked by a meltdown in subprime mortgage markets in the second half of the year. The ETF also held relatively little in consumer staples and materials stocks. By contrast, it had around 24% in tech heading into the fourth quarter and 18% in health care. Industrials and Energy names also were big contributors.

As a result, the portfolio had a higher price-earnings ratio than the S&P 500. "You've got a large-cap fund with a very growth-oriented portfolio. So you'd expect it to outperform when large growth does well, as it did last year," said Rick Ferri, author of The ETF Book.

He believes that OTP's emphasis on using a theme to invest had more to do with its 2007 results than any quant methodologies thrown into the mix.

"The way they screened stocks happened to come up with companies that overweight sectors that were hot last year. But with a 4% annual turnover rate, they're going to keep buying these same types of companies," Ferri said.

Assuming the ETF's theme remains the same over the long run, Ferri says "it's fair to expect OTP to underperform when value rebounds."

At least in 2007, more traditionally constructed stock ETFs didn't fare as well as many quant funds. Along those lines, iShares Morningstar Large Core (NYSE Arca: JKD) gained 8.5%. Meanwhile, Vanguard Large Cap ETF (AMEX: VV) was up 6.4%, SPDR Dow Jones Wilshire Large Cap (AMEX: ELR) made 6.2% and iShares S&P 500 (NYSE Arca: IVV) finished with a 5.4% return.

Year of Quant ETF?

Before claiming 2007 as the year of the quant ETF in stock markets, consider the divergence within the group. Even among the undisputed leader of the pack in terms of numbers of offerings, last year saw a wide assortment of different returns.

At the end of last year, PowerShares has 43 different quant funds. Almost all of those were based on so-called Intellidex benchmarks. Besides using more valuation and risk ratios to select stocks than traditional market-cap index funds, these ETFs can reconstitute their portfolios more often as well.

Perhaps the clearest comparisons between such quant strategies and more passive ones can be made by drilling below the surface of broad-based, well-diversified portfolios from both camps.

The PowerShares Dynamic Large Cap Value ETF (AMEX: PWV) certainly fits that bill. It boasts extremely low turnover rates and actually has a broader investing universe than a similar rival such as the iShares Russell 1000 Value Index ETF (NYSE Arca: IWD).

The difference in stock-picking methodologies, however, creates divergent portfolios. While IWD has 600-plus different stocks, PWV holds around 50. Also, the Intellidex quant fund has been more skewed toward Financials and Health care while IWD has tended to hold more Industrials and Energy.

Even more to the point last year was that PWV held a much larger contingent of mega-cap firms. That meant it benefited more from a shift in sentiment to bigger blue chips.

It's not surprising that returns last year were much different, with PWV gaining 5.3% and IWD losing 0.7%.

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