Smart Beta ETF strategies (or factor investing) is one of the fastest growing trends in investment management. The inflows to these strategies has seen double digit growth in asset under management and outpacing the growth of traditional index funds.
Traditionally, passive index funds tracks the performance of an equity index with the stock weights based their market capitalization. The larger the value of the company, the greater weight the company is in the index. The nature of the structure of market cap index results in the performance of the index funds biased towards larger stocks which overtime gives investors the benefit of survivorship bias.
There are a number downside from just using market capitalization as proxy for portfolio weights.
- Large companies by law of large numbers usually grow slower than smaller 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 Smart Beta ETF are designed to be at the intersection of index tracking ETFs and actively managed funds. It has 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. The portfolio creation is based on historical tests of specific factors which shows greater source of returns or lower volatility for a set of return profile.
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.
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.
Examples of Smart Beta Strategies
SPDR S&P 500 (SPY) similar to the Australian index fund equivalents 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. Smart beta funds are separated into distinct strategies that includes securities in the fund on an equal basis, fundamental or volatility weighted methodologies.
Equal weight ETF – Equal weight strategies means exactly as it sounds. The weight of companies are the same and the fund is rebalanced quarterly. For example every stock in the ETF is weighted 0.25% and as long as the stock is included in the underlying index it will be included in equal weighted fund. This is a more mean reversion approach to portfolio management such that winners as sold and losers are bought to the same position at fixed intervals.
Volatility Constant ETF – Another smart beta approach is through weighing the exchange fund holdings by volatility. The weight of individual positions are based on the underlying volatility of the stock, whereby higher volatile stocks have reduced impact on the portfolio and inversely the portfolio will be overweight lower volatile stocks.
This strategy is designed to provide a more stable portfolio while maintain growth exposure. The thesis is that returns are not everything in investing. A volatility constant ETF tracking an index allows investors exposure to an index with minimal volatility position.
Stock Buyback ETF – These are funds which select stocks that has ongoing or historical track record of implementing a buyback program covering more than 5% of the outstanding shares. Creation of Buyback ETF is based on the research which shows companies undertaking buybacks outperform its peers following announcement of buy backs even after 12 months. Buyback ETFs can be further segmented by funds focusing on US companies or international companies only (Japan or UK).
Dividend ETF – An investment portfolio which weights companies in the portfolio based on the history of dividend growth and yield. Listed dividend funds are designed to target income driven investors with a higher risk tolerance than fixed income investors. Investors need to be aware that the higher yields of dividend ETFs vs Bond ETF is because investors are still taking on equity risk rather than credit risk which is more secured position in the companies capital stack.
Smart Beta Bond ETF
The above examples of smart beta or factor ETF does not only apply to equities. The same strategies can be adopted for fixed income asset class.