Smart Beta ETF strategies is one of the fastest growing trends in investment management. ETF providers has seen double digit growth in asset under management within the Smart Beta funds with $250 billion asset under management.
Traditional passive index funds tracks an index and the weight of companies in the index are typically based on the their relative size or market capitalization. The large listed equity value, the greater weight it would have in the index. By this nature, the performance of the index funds is biased towards larger stocks.
There is a number flaws in using market capitalization as proxy for portfolio weights.
- By law of large numbers, large companies usually grow slower than smaller companies. Therefore current market cap weighted ETFs are biased towards slower growing companies.
- Market capitalization does not equal value. For example, NASDAQ index reached above 5000 in 2015. The last time it was above 5000 was during the technology bubble. An index selecting stocks based on investment fundamentals or return factors could avoid severe losses and buying overvalued stocks.
The development of Smart Beta funds is aimed in creating a cross section between passive and actively managed funds. Smart beta takes specific factors from active management universe and instill it in a passive listed fund. Active management in the context of smart beta does not necessarily mean there is a fund manager picking stocks within the smart beta fund. Rather the funds is created by a predetermined rules in deciding what kind of stocks goes into the index.
The Smart Beta ETF list created below are some funds that were created as result of the intersection. It aims to have the best of both worlds matching the positive features of ETF investing such as low cost and transparency with degree of flexibility of strategic security selection seen in active management.
Investing through Smart Beta ETFs is still a passive strategy. However once the underlying index and security selection methodology is determined, the managers of ETF does not have discretion to deviate from the strategies or pre set rules.
Smart beta funds are separated into distinct strategies that includes securities in the fund on an equal basis, fundamental or volatility weighted methodologies. There are also dividend paying ETFs which has mix of indexing and smart beta strategies.
iShare Smart Beta ETF
iShares created a specific family of smart beta exchange trade funds which provide additional investment options for investors. The primary factors of these funds are based on quality, value, size and momentum.
iShares MSCI USA Quality Factor ETF (QUAL) is a quality smart beta fund. With 130 different companies in the ETF. Stocks in the fund are screened based on a preset set of fundamental quality. These qualities are
- Return on equity (ROE)
- Year on year earning growth
- Low debt levels
From reviewing the underlying securities holdings there are some major sticking points. Firstly by using the above quality factors in the screening process. The fund would be heavily weighted in the technology space. This is by nature tech companies have high return on equity, little debt and usually grows fast.
Investors should note however that the ROE metric should be used cautiously with technology companies. This is because ROE is a book value measurement which is only an accurate representation of performance if the stock traded close to tangible book.
ROE for technology companies can be an inflated measurement of performance because most of the assets in the technology companies like google or Facebook are not tangible assets but intangible assets. The stocks price of these companies usually trades a large multiple of the underlying book value.
The requirement of low debt levels mean that the financial sector has the smallest sector exposure in the fund.
iShares MSCI USA Value Factor ETF (VLUE) is value smart beta ETF. The aim of the fund is focus on stocks that are traded on a low valuation based on a fundamental screening. Potential downside of this is it could be investing in value trap companies where they are priced on a low valuation for a reason.
Note iShares provides a US and International version of the funds. We have provided summary of the US versions only.
Smart Beta Dividend Investing
There are a number of options for dividend hungry investors. First Trust Value Line Dividend Index Fund (FVD) is one such example. FVD equal weights stocks that has a dividend yield higher than S&P 500 index. The fund also rebalance on a monthly basis.
FlexShares Quality Dividend Index Fund (QDF) is another smart beta fund which uses proprietary model in improving selection of stocks that are included in the Northern Trust 1250 index. The primary factor it looks to improve on are the index beta and yield.
Market Smart Beta ETF
SPDR S&P 500 (SPY) is the largest market index ETF. It tracks the S&P 500 which is a market capitalization index fund. The weights of the 500 largest US listed stock is dependent on the size of the company. As a result, S&P5 500 is known to have a bias towards overvalued stocks. Note inverse market ETFs are not considered to be smart beta ETFs.
Guggenheim equal-weight ETF (RSP) is an equal weighted S&P 500 ETF. Equal weight means exactly as it sounds. It ignores the size of the company, rather every position in the fund is rebalanced to the same weight quarterly. For example every stock in the smart etf is weighted 0.25%. As long as a stock is included in the S&P 500, it will be included in RSP on an equal weighted basis.
Another smart beta approach of tracking S&P 500 is through weighing the exchange fund holdings by volatility. PowerShares S&P 500 Low Volatility (SPLV) is one such vehicle investor favour with this methodology.
Smart Emerging Market Bond ETF
Our detailed research on Emerging Market Bond ETFs shows PowerShares Emerging Market Sovereign Bond ETF (PCY) has an interesting approach in investing in emerging market bonds vs other emerging market bond ETFs.
PCY tracks the DB Emerging Market USD Liquid Balanced Index PCY which manages emerging market bond portfolio through equal weighted exposure to countries in the fund.
The difference between the largest and the smallest position in PCY is only 0.50%. It can be considered a mean reversion play on emerging market performance as frequent quarterly rebalancing means selling the best performer and buying the under performing bond.
Stock Buyback ETFs
PowerShares Buyback Achievers (PKW) is an fund that select stocks that is implementing a buyback program covering more than 5% of the outstanding shares. Creation of Buyback ETF is based on the research showing companies outperform its peers following announcement of buy backs even after 12 months.
- The fund invests in well known companies listed in the United States with average market capitalization of $50 billion.
- Not surprisingly ETF focusing on stock buying back large portion of its own stocks is biased towards companies with excess cash. ETF dividend yield is just a notch above 0.50%.
- Average ROE is above 20% and with P/E of 15 shows PKW still could have more room to run.
Invesco riding on the success PKW created an International Buyback ETF (IPKW) which invest in mostly non US companies buying back large portion of their stock. PKW provides international exposure for investors with an added layer of cushion of companies flush with cash. Investor should be aware of potential liquidity risks as IPKW only has less than $50 million asset under management.
IPKW country exposure breakdown shows Japan and UK account for half of the fund with top 10 countries accounting for 90% of the fund.
The smart beta ETF list highlight some distinct strategies implemented by ETF providers. Investors appetite for smart beta as opposed to index tracking funds is expected to grow going forward.