Smart-beta exchange-traded funds (ETFs) have become increasingly popular over the past few years. Like passively managed funds, smart-beta ETFs invest in indexes with a focus on low costs, but they also take a slightly more active approach than passively managed funds by using criteria other than market-capitalization weights to determine portfolio allocations. The idea is to provide the benefits of actively managed funds without the high costs.
While smart-beta funds started small, the asset class has grown to over 600 ETFs that account for about 40% of the total market. These ETFs invest in indexes weighted by factors other than market capitalization, geography or sector. This includes everything from “momentum” factors using technical analysis to “value” factors using price-earnings ratios. Investors can use these different factors to craft a portfolio that fits their unique needs.
In this article, we’ll look at smart-beta ETFs that investors might want to consider to add yield to their income portfolios.
Smart-Beta Fixed Income
Traditional fixed-income ETFs operate on a kind of twisted logic. Market-capitalization weighting means investors have the greatest exposure to the most indebted issuers, rather than those with the best credit quality. Smart-beta funds use fundamental factors as an alternative weighting mechanism, such as cash flows that can support debt repayment or credit ratings by major ratings agencies that can help reduce exposure to riskier bonds.
Some of the most popular smart-beta fixed-income ETFs include:
|PowerShares Fundamental High Yield Corporate Bond Portfolio
|High-yield corporate bonds selected based on cash flow and other fundamental factors.
|Vident Core U.S. Bond Strategy ETF
|Diversified U.S. bonds selected based on governance and creditworthiness.
|PowerShares Emerging Markets Sovereign Debt Portfolio
|Emerging market bonds equally weighted across countries, but screened for liquidity and value.
Investors may want to consider these smart-beta fixed-income ETFs as a way to reduce risk in their bond portfolios, particularly with interest rates poised to move higher in the near- to intermediate-term. For example, PHB may eliminate holdings in riskier energy-focused corporate issuers that may struggle to repay debts as interest rates rise, since it screens for cash flow and other fundamental factors in creating its index.
Of course, it’s important to remember that reduced risk comes with an opportunity cost when it comes to returns. Many fixed-income smart-beta ETFs are focused on high quality issuers, which tend to yield less than riskier issuers. This means that investors may find these smart-beta funds returning less in good times, but they may offer greater downside protection in the event that the market becomes significantly more risky.
Equity dividends represent another area of the market where smart-beta ETFs may be able to offer an advantage over traditionally weighted funds. Smart-beta funds in these areas tend to focus on fundamental quality, dividend paying consistency and low volatility as weighting metrics, in order to build an ideal portfolio for income investors. Investors should consider their specific needs when deciding between these options – whether its safety or yield.
Some of the most popular smart-beta dividend ETFs include:
|FlexShares Quality Dividend Index Fund
|Fundamentally sound U.S. dividend stocks with a beta of near 1.0 and minimal risk.
|First Trust Value Line Dividend ETF
|Top rated Value Line™ stocks that offer above-average dividend yields.
|ProShares S&P 500 Dividend Aristocrats
|S&P 500 companies that have grown dividends for at least 25 consecutive years.
Investors may want to consider smart-beta dividend funds as a way to add income to their portfolios without the risks associated with fixed income. Those looking for cheap exposure to high quality dividend-focused components of the S&P 500 may want to consider NOBL, while those looking for greater yields can consider QDF as an alternative. Other ETFs in the space may offer exposure to international companies or low-volatility stocks.
It’s important to keep in mind that these ETFs share the same risk factors as any dividend stock. In today’s low-yield environment, these companies may have high valuations that could fall, in the event that interest rates rise. These dynamics could lead to lower share prices, which could reduce the value of these ETFs. The good news is that some funds may be less impacted than others, such as the NOBL fund that invests only in larger companies.
The Bottom Line
Smart-beta funds provide income investors with many different options for boosting their portfolio yields, including both fixed-income and dividend-focused funds. Rather than weighting based on market capitalization, these funds are focused on other factors that may provide better risk-adjusted returns, such as fundamental quality or volatility. The true fit for an investor, however, will largely depend on their investment goals.