Over the past decade, the ETF market has expanded in size, scope and complexity. Once designed to simply track the broader stock and bond markets, ETFs today offer more opportunity to boost returns at each stage of the market cycle. One such strategy is the smart beta system, which attempts to outperform the market via alternative indexes that capture market inefficiencies. So, what makes smart beta ETFs so smart? Read on to find out.
In the financial industry, the term “beta” simply refers to the risk and return of the overall market. “Smart beta” is therefore an attempt to build an alternative index to outperform the overall market. In a low-yield environment characterized by weak growth, geopolitical risks and financial instability, ETF investors are looking to build dynamic portfolios that create opportunities not offered by linear index funds.
Smart beta investing is just one of the more popular ways of implementing a factor investing strategy. Factors are the foundation of an investment portfolio that investors rely on to mitigate risk, outperform the market and derive consistent gains at each stage of the market cycle. A strategy that employs factor investing chooses financial assets based on attributes that are typically associated with higher returns, including size and risk.
Within this context, smart beta investing seeks to develop new forms of indexation that can achieve profitable results in an increasingly volatile and risk-prone market. In this vein, smart beta investing is an efficient, relatively low-cost way of leveraging the factors that can potentially boost your returns while lowering the risks.
Smart beta funds come in two flavors – single-factor and multi-factor – depending on the factors influencing the funds’ risk-return profile. The motivation for using multiple factors is to minimize long periods of underperformance in a portfolio since, at any given time, not all factors are outperforming. To find out more about the two types of smart beta approaches, read Smart Beta: Single Factor vs. Multi-Factor Approaches.
Below are eight factors smart beta investors look at when constructing their portfolios.
Volatility is a risk measure of how much the price of an asset fluctuates. Investors building a smart beta strategy often look for less volatile assets that provide consistent returns over time. The standard deviation is the most basic statistic used to measure volatility. Low volatility plays have the potential to outperform the markets during periods of uncertainty and fear, which tend to depreciate the value of stocks and other riskier assets. Some behavioral biases associated with low-volatility trading include conservatism and zero-risk bias. Examples of low volatility ETFs include PowerShares S&P 500 Low Volatility Portfolio ETF (SPLV ), iShares MSCI Emerging Market Minimum Volatility ETF (EEMV ) and iShares MSCI All Country World Minimum Volatility ETF (ACWV ).
In finance, “momentum” refers to the acceleration of an asset’s price, earnings and revenue, where applicable. Momentum factor ETFs aim to provide long-term growth by capturing excess returns in high-quality securities. Momentum factoring provides exposure to assets with higher price momentum. Common metrics associated with this factor include historical alpha and relative returns. Momentum plays can outperform the market in virtually any cycle because they rely on assets with recent strong performance. Common behavioral biases associated with momentum investing include the ostrich effect, recency, salience and selective perception. Some examples of momentum ETFs include iShares MSCI USA Momentum Factor ETF (MTUM ), Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC ) and SPDR Russell 1000 Momentum Focus ETF (ONEO ).
Value characteristics include the price-to-earnings or price-to-book ratios of an underlying asset. These factors allow investors to determine the relative value of one stock against others. Research has shown that, on average, more affordable securities tend to outperform more expensive ones over time. Common metrics for evaluating value factor plays include book to price, earnings to price, sales, earnings, cash earnings, net profit and dividends. Value factors tend to produce strong upside, but also have several behavioral biases associated with them, including stereotyping, selective perception, overconfidence, and outcome and blind-spot biases. Some popular ETFs in this category include iShares MSCI International Developed Value Factor ETF (IVLU ), iShares MSCI USA Value Factor ETF (VLUE ) and SPDR S&P 1500 Value Tilt ETF (VLU ).
Small capitalization is a well-known systemic factor used in smart beta investing. Small-cap factors capture excess returns of smaller securities relative to their larger industrial counterparts. The rationale behind investing in small caps is that they tend to outperform large caps over the medium and long term. Small-cap factors are measured by the market capitalization (full or free float) of the underlying security. While effective, small cap tends to produce the following biases: availability heuristic, anchoring bias, ostrich effect and salience. Examples of small-cap ETFs include iShares Russell 2000 ETF (IWM ), Vanguard Small-Cap ETF (VB ) and iShares Core S&P Small-Cap ETF (IJR ). Use our Head-To-Head ETF Comparison tool to compare two small-cap ETFs on several criteria such as performance, AUM, trading volume and expenses
Income investors rely on high dividend stocks to boost their portfolio over time. Smart beta strategies that leverage dividend yield benefit from excess returns on equities that produce higher-than-average dividend yields. Naturally, the stock’s dividend is the main metric associated with this factor. Strong dividend yielding stocks typically have a strong record of paying out profits, making them well positioned to outperform during cyclical downturns and periods of higher volatility. Common behavioral biases associated with dividend factors include selective perception, salience, overconfidence and choice-supportive bias. ETFs that capture high dividend yields include Vanguard Dividend Appreciation ETF (VIG ), SPDR S&P Dividend ETF (SDY ) and PowerShares S&P 500 High Dividend Low Volatility Portfolio ETF (SPHD ).
Quality is one of the most widely used factors in choosing a sound investment. It is generally well accepted that higher quality assets produce the best outcome, especially in bullish market cycles. High quality assets can also serve as defensive plays during economic downturns. When evaluating quality, investors usually look at factors such as profitability, industry fundamentals and the performance of the underlying business. Investors on the prowl for quality plays should keep a lid on the following behavioral biases: information bias, choice-supportive bias, confirmation bias and the bandwagon effect. Some quality factor ETFs include iShares MSCI USA Quality Factor ETF (QUAL ), SPDR MSCI World Quality Mix ETF (QWLD ) and FlexShares Quality Dividend Index Fund (QDF ).
Factor credit strategies seek to maximize the portfolio’s factor exposure while limiting exposure to risk. These strategies prioritize the credit quality of an underlying asset with the aim of ensuring sustainable returns over time. Credit bond ETFs capture investment-grade corporate, sovereign, local authority and agency bonds. They are positively correlated to economic activity and typically provide low-cost access to domestic and international credit markets. When evaluating the credit factor, investors typically look at credit exposure, particularly through factors such as leverage and cash flow coverage. Some common behavioral biases for credit factor investing may include information bias and choice-supportive bias. Some ETFs within this category include Vanguard Short-Term Corporate Bond ETF (VCSH ), iShares iBoxx High Yield Corporate Bond ETF (HYG ) and Vanguard Short-Term Bond Index Fund (BSV ).
In bond investing, the rationale behind term factors is that long-maturity bonds outperform short-maturity bonds. Factors such as inflation uncertainty and supply and demand impact term factor strategies. Zero-risk bias and other forms of risk aversion are common behavioral biases associated with this factor. Common long-term bond ETFs include iShares 20+ Year Treasury Bond ETF (TLT ), Total International Bond ETF (BNDX ) and UltraShort Barclays 20+ Year Treasury ETF (TBT ).
For more information on behavioral biases, and how they potentially impact your investing behavior, take a look at How to Battle Your Investing Biases.
While there are numerous benefits to factor investing using smart beta strategies, there are some drawbacks that investors need to be aware of before continuing down this path. Compared to traditional index funds, factor-based strategies are often riskier and more likely to feature “flavor of the month” products that simply aren’t proven. That means this burgeoning industry is likely to have some major duds. Additionally, several smart beta strategies carry higher expense ratios and rebalancing costs when compared to traditional index funds. Many factor-based strategies are inherently high-risk, high-reward. While this is a perfectly acceptable value proposition in finance, investors may not be accustomed to the same risk-reward ratio when investing in ETFs.
The Bottom Line
Factor investing has become a key pillar of today’s ETF market. As the conversation around ETFs continues to expand, we are likely to see continued refinement in the portfolio construction process. Smart beta strategies are one effective way investors can integrate factor-exposure decisions into their portfolio with the aim of outperforming the broader market. By realizing the power of factors and remaining cognizant of the potential risks, ETF investors can work toward maximizing returns regardless of the market cycle.
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