As more investors realize the power of indexing and its effects on long-term returns, more are choosing smart beta ETFs for their portfolios. By screening for various fundamental factors, smart beta indexes hope to overcome many of the issues with traditional market-cap weighting techniques. These include large-cap biases and owning “bad” stocks.
Yet, while smart beta continues to grow in popularity, most investors are using the ETFs as satellite positions or as a way to supplement a traditional indexed portfolio.
But with the proliferation of new smart beta ETFs, you can build a successful core portfolio with them exclusively, covering a full range of asset classes. And with returns on many smart beta indexes slightly outperforming regular ones over the long term, there’s plenty of incentive to do just that.
Here’s ETFdb’s Smart Beta Core Portfolio.
Guggenheim S&P 500 Equal Weight ETF (RSP )
Large-cap U.S. stocks form the foundation of any portfolio and the broad S&P 500 is the most tracked index of large-cap stocks. The problem with the S&P is that it’s market-cap weighted. That means the larger stocks in the index have more pull than the smaller ones. By equal-weighing the portfolio, smaller stocks and faster moving stocks also have the ability to move the index.
RSP does just that by tracking the S&P 500 Equal Weight Index and it’s been a great performer. Over the past ten years, the equally weighted broad stock benchmark has managed to beat its traditional market-cap counterpart by a full two percentage points each year over the same time period. That’s a significant performance difference for basically doing nothing special. As such, RSP should be in every investor’s portfolio. Even more so when you consider that the expense ratio for the smart beta ETF is only 0.40%.
PowerShares FTSE RAFI 1500 Small-Mid Portfolio (PRFZ )
Small- and mid-caps have often been a major source of growth for portfolios over the long haul, with both market-caps beating large-cap stocks. The PRFZ owns both in one ticker.
The smart beta ETF tracks the RAFI US 1500 Small-Mid Index and screens for book value, cash flow, sales and dividends to create its portfolio. The fund’s 1,496 holdings are assigned weights based on these fundamentals. Performance of the Index and ETF has been great. PRFZ has managed to bank more than 2% in extra returns on average annually over the last nine years (since inception) versus the small-cap Russell 2000 Index.
PRFZ charges just 0.39% in expenses.
Schwab Fundamental International Large-cap Company ETF (FNDF )
In today’s global economy you can find foreign products in every facet of life. After all, there are numerous Hondas on America’s roadways and Bayer aspirin in our medicine chests. With that in mind, international stocks belong in the core of your portfolio.
FNDF screens for average sales, retained operating cash flows, dividends and share buybacks over the past five years to create a portfolio of international stocks. The metrics are what give the “value” tilt. Over time, value stocks generally beat growth stocks and FNDF is no different. Its index, the Russell Fundamental Developed ex-U.S. Large Company Index, has managed to outperform the MSCI EAFE Value Index by 2.6% annualized. Expenses for FNDF run just 0.32%.
SPDR S&P Emerging Markets Dividend ETF (EDIV )
Dividends are a major source of total returns and nowhere is that more prevalent than in emerging markets. Many emerging-market firms have a history of paying strong dividends thanks to family and insider ownership structures. More importantly, these dividends help stem the excess volatility associated with the asset class.
EDIV tracks the S&P Emerging Markets Dividend Opportunities Index, which tracks 100 stocks from emerging markets with high dividends. Over the longer haul, these dividends have helped EDIV outperform broad benchmark emerging-market indexes. Expenses for the smart beta ETF cost 0.49%.
FlexShares Credit-Scored US Corp Bond ETF (SKOR )
Most smart beta ETFs focus on stocks. However, bonds benefit from smart beta indexing, too. That’s because most regular bond indexes focus on the amount of debt issued, not quality. In essence, most bond indexes bet on the most indebted companies or nations.
SKOR takes a different approach by using a proprietary model for credit scoring. The smart beta fund will then optimize its constituents to maximize the credit score while maintaining duration, spread, and other characteristics of intermediate corporate bonds. Basically, SKOR kicks out bad payers or those firms that have the potential to default and keeps only the good guys, and you get a portfolio of bonds that shouldn’t default. The fund is new, but so far it’s managed to beat traditional corporate bond indexes by about 1% since its inception.
The expense ratio for SKOR is a low 0.23%.
The Bottom Line
Smart beta ETFs continue to grow in popularity and numbers. Today, it is possible to build an entire portfolio out of the fundamental indexes that should outperform traditional market-cap indexes by a wide margin. The preceding picks are a prime way to do just that across the various asset classes, regions and stock-sizes/market caps.
Disclosure: No positions at time of writing.
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