May 16, 2019
Investors who are nervous about stock-market swings and loathe to put assets in safer bonds are turning to smart-beta strategies.
Smart-beta exchange-traded funds have proliferated in the past several years. These ETFs use academic research to take advantage of long-term market trends in an attempt to outperform stock market benchmarks. After the fourth quarter stock market sell-off, low-volatility smart-beta ETFs are viewed as mitigating the impact of stock market gyrations became some of 2019’s most popular ETFs judging by asset flows.
Experts say these ETFs can help investors avoid losses, but it’s important to understand how these assets work.
Here are a few things to learn:
- The definition of a smart beta ETF.
- Selecting the right smart-beta fund for your portfolio.
- Knowing how these funds can help mitigate losses.
Defining Smart Beta
Smart beta, also called factor investing, is rooted in academic research from Eugene Fama, a professor at the University of Chicago’s Booth School of Business, and Ken French, a finance professor at the Tuck School of Business at Dartmouth College. They found certain investment factors such as a company’s size, a firm’s price-to-book ratio and market risk would over time outperform the broader S&P 500 index.
Another way to think about smart beta is that it’s an alternative way to weight a security on something else besides its market capitalization, or the value of its outstanding shares. Beta means how risky a stock or portfolio is to the broader market.
Active managers at institutional firms used these strategies for decades. ETF issuers started to incorporate this research, but created rules to replicate the research and apply it to passive indexes. This makes smart-beta ETFs a cheaper alternative than buying actively managed mutual funds, in which portfolio managers select stocks based on certain criteria.
Portfolio Strategies With Smart Beta ETFs
Todd Rosenbluth, senior director of ETF and mutual fund research for CFRA in New York City, says for extremely risk-averse investors who still want some equity exposure, low-volatility ETFs can be a core part of their portfolio, perhaps replacing a typical S&P 500 or Russell 1000 ETF. For investors who are only moderately risk averse, these ETFs can be a complement to an existing portfolio.
One example is Invesco S&P 500 Low Volatility ETF (ticker: SPLV), which is comprised of the 100 least risky stocks in the S&P 500 index. He says that this ETF is designed to be only three-quarters as risky as the broader S&P 500 index.
Kip Meadows, founder and CEO of Nottingham, a fund administration firm and white-label ETF issuer in Rocky Mount, North Carolina, says the theory of smart beta or factor investing posits that qualitative decisions can help investors pick higher quality companies.
“It’s like a hedge strategy,” Meadows says. “If you have a downturn, the theory is the company that has the better fundamentals, like a higher dividend, it should outperform and provide investors protection.”
Dividend-strategy ETFs are another risk management tool. Rosenbluth says dividend-strategy ETFs come in different types, such as dividend growth like ProShares S&P 500 Dividend Aristocrats ETF (NOBL), which is constructed based on how consistent the company has been on paying or raising dividends. Another dividend-focused ETF is iShares Core High Dividend ETF (HDV), constructed based on yields. “The yield-centric ones tend to be less volatile, while the dividend-growth ones are closer to a traditional core strategy,” he says.
Smart-beta investing is about portfolio stability, rather than seeking out hot investments for outsized returns, Meadows says.
These Funds Can Help Mitigate Losses
Craig Bolanos, CEO of Wealth Management Group in suburban Chicago, says factor investing is not new, but what is new is the ability to access these investments through smart-beta ETFs.
Bolanos says he saw wider adoption of some of the smart-beta strategies like low volatility during the fourth-quarter market sell-off last year because these strategies help mitigate some losses. That doesn’t mean people made money, it just means they didn’t lose as much.
Rosenbluth says investors must understand smart-beta strategies aren’t foolproof. They help limit losses in down times, not prevent them. More often than not, these ETFs will have less negative return compared to other funds during a volatile market.
“The appeal of these is that instead of trying to time the market by moving in and out of cash or bonds, you could (benefit) from some the smart-beta characteristics. But these are not safe investments. They’re safer investments,” he says.
In 2018, SPLV’s annual return was essentially flat, up 0.03%, while the SDPR S&P 500 Trust ETF (SPY) was down 4.45%.
Further, the risk-averse smart-beta ETFs will also lag the broader market during rallies because they invest in the defensive areas of the market, like consumer staples and utilities, which often lag in a rally.
With the stock market volatility and an economy in a late cycle, people have too much equities exposure, Bolanos says. He adds that there’s a lot of risk out therein a late-state bull market, and people need to move to safe investments for when the stock market corrects itself.
“If my job as a financial counselor is to get people to do what’s in their best interests, but it’s too hard of a hurdle to get them to buy bonds, factor-based investing under the guise of minimum volatility allows us to move people’s equity exposure into something that’s more palatable for their stage of life,” he says.
Although the past doesn’t predict the future, Meadows says the academic research behind smart-beta strategies focuses on what characteristics of investing do well over time. The biggest attribute an investor needs when it comes to using smart beta ETFs is patience.
“These are long-term investments,” he says. “The longer term strategy can help you lose less.”
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