What Smart-Beta ETFs Can (and Cannot) Do for Fundamental Investors

One of the questions posed by those hesitant to adopt this breed of products has been: what is the appeal of smart-beta ETFs for hands-on, self-directed fundamental investors?

Traditionally, passive investing has been synonymous with a market capitalization-weighted approach to portfolio construction, meaning that the biggest constituents make up a larger share in respective indexes.

Active Meets Passive

Smart beta aims to improve upon the notion of “buying the market”, or “beta”, by using a rules-based fundamental screening and portfolio construction methodology. It is essentially a “smart” blend of active and passive. It’s active in that it seeks to outperform the market, or cap-weighted indexes, over time. But it’s also passive in that the strategies are rules-based and the ETF wrapper is transparent as well as cost-efficient.

In this respect, smart beta is thought to have the “best of both worlds” by some.

Factors That Matter Most

At its core, smart beta is about isolating and capturing the outperformance associated with any one, or several, proven investment factors. What exactly does that mean?

For starters, an investment factor can be defining risk/return characteristics of a security; for example, market-cap size or dividend yield. Next, smart-beta strategies look to focus on those factors, overlaid on a universe of securities, which have proven to deliver outperformance over cap-weighted indexes, with some of the most common ones being:

1. Value: Securities trading at discount valuations to the broader market and peers.
2. Momentum: Securities with market- and industry-beating performance.
3. Size: Securities with smaller market capitalizations.
4. Volatility: Securities with more stable returns than the market and peers.
5. Quality: Securities that meet a rigorous checklist of investment criteria, spanning strong past and projected earnings growth, low leverage, and rock-solid balance sheets.

Be sure to also consider the following resources:

• Vanguard explains factor investing.
• MSCI’s foundations for factor investing.
• Russell Investments explains equity factor investing.

The next assumption in the main question that ought to be addressed is what do fundamental investors look at?

There are many strategies we can discuss here, but most have these themes in common:

• Security-Specific Analysis: For starters, investors will screen companies based on metrics such as free cash flow, dividend yield, momentum, or market cap before doing more research, which entails digging through earnings reports, SEC filings, and getting your hands dirty with the company books so to say.

• Industry Analysis: Investors will also perform some sort of valuation analysis and peer group comparison, covering everything from price-earnings to price-book to EPS growth metrics. They also need to be aware of any pending regulatory, cross-industry, and macro risks.

When all is said and done, the above list is just a starting point. This type of approach generally requires a lot of homework on the part of investors who want to keep up, and for many, though certainly not all, this amount of research and active management is simply out of scope.

Smart-beta ETFs truly simplify the ongoing research and portfolio management process for those who see the merit in factor-based investing. The fact that smart-beta ETFs are rules-based is a major point of appeal. After all, investors know how challenging it can be to battle their own biases, and so smart-beta ETFs can help by easing this burden almost entirely; though investors still need to pick a smart-beta fund among a growing product list.

The other allure is all the benefits that come with the ETF product structure, namely cost-efficiency, intraday liquidity, and transparency. Replicating a smart-beta strategy on your own is both a costly and timely endeavor.

Read more about How to Battle your Investing Biases.

Factor-based investing, much like the performance of any strategy, comes with its drawbacks. The biggest one is cyclicality among the factors. Consider the below from ETF Securities, a provider of multi-factor smart-beta funds, comparing the various factors over time:

The takeaway here is that on their own, each of the factors is quite cyclical; that is to say, one year size is the worst performer, and the next year it’s the best.

Read more about Single Factor vs. Multi-Factor.

Furthermore, even the multi-factor approach trails the market-cap average in some years, once again highlighting that any strategy is susceptible to periods of underperformance.

The last drawback is that some investors just won’t find their favorite fundamental strategy in the smart-beta wrapper. While many of the most popular strategies, be it low volatility or dividend growth-focused, can be indexed, the rules-based framework does come with drawbacks that will inherently turn away those who find comfort in the discretionary aspect of actively managed funds.

For example, an investor could have a strategy revolving around increasing/decreasing security positions immediately after earnings are reported, in which case the high turnover of their strategy would most likely not lend itself to a smart-beta ETF.

Put another way, smart-beta funds cover a lot of the fundamentals-focused strategies out there, but not all of them.

See all Smart-Beta ETFs.

Some common single factor-focused funds include:

• Value ETFs.
• Low-Volatility ETFs.
• High-Momentum ETFs.

The appeal of smart-beta ETFs for fundamental investors is straightforward: these funds can help to make their lives easier and improve portfolio performance. Don’t forget about the drawbacks, however, like the cyclicality of factor-based investing and the fact that not every strategy lends itself nicely to the ETF wrapper. Be sure to do your homework on any smart-beta product, be it single or multi-factor, before making an allocation.

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