The best way to “play” smart beta is to favor those factors that are cheap versus their own history.
Both our US- and the World-Smart Beta portfolios show an outperformance (for the time being).
Quality is the most interesting factor for now.
Both portfolios were able to outperform, both in relative and absolute terms:
The Smart Beta World-portfolio was heavily underweight US and overweight international and emerging markets and this paid off nicely.
While one generally proposes to equal weight the different smart beta factors in one portfolio, we want to take the valuation of the different factors into account for our portfolio construction. Just like stocks, bonds, sectors or countries, smart beta factors can become cheap or expensive. We expect that when the valuation of a factor is low compared to its own history, that factor is poised to outperform. And vice versa, when the valuation is high it is likely to disappoint.
When we look at the GMO 7-year asset class real return forecast, who have proved to be very accurate over longer term horizons, we have to conclude that quality stocks have relatively a much more compelling valuation compared to small caps (and the stock market in general).
Compared to the previous quarter the return forecast is lowered for US and emerging stocks and increased for international stocks. Besides that, international large cap and certainly emerging market stocks continue to offer higher expected returns compared to US stocks.
Each quarter State Street Global Advisors publishes global long term smart beta forecasts. In the below graphs you can see that Value and Size have recently become more expensive, while Quality remains attractive. Low Volatility has moved from expensive toward neutral or fair value.
Smart Beta US Portfolio
Based on the above valuation-information we constructed the following Smart Beta US-portfolio:
Changes in portfolio composition versus last quarter:
Compared to the previous portfolio-composition the weight of iShares Edge MSCI Minimum Volatility USA ETF (NYSEARCA: USMV) is increased from zero to 11.4%. The weight of iShares Edge MSCI USA Momentum Factor ETF(NYSEARCA: MTUM) and iShares Edge MSCI USA Quality Factor ETF (NYSEARCA: QUAL) is lowered, but their weight remains overweight c ompared to an equal-weight factor-portfolio.
The allocation to iShares Edge MSCI USA Value Factor ETF (NYSEARCA: VLUE) and iShares Edge MSCI USA Size Factor ETF (NYSEARCA: SIZE) is slightly increased, but remains underweight c ompared to an equal-weight factor-portfolio.
When we look at the Smart Beta US sector allocation, we can see:
- an overweight position (compared to the S&P 500) in Consumer Discretionary, Financials, Real estate and Technology and
- an underweight allocation in Industrials, Energy and Consumer Staples.
Smart Beta World Portfolio
Based on the same above valuation-information we constructed the following Smart Beta World-portfolio:
The biggest positions are:
- iShares Edge MSCI Min. Vol. EAFE ETF (NYSEARCA: EFAV),
- iShares Edge MSCI Multifactor Emerging Markets ETF (BATS: EMGF),
- iShares Edge MSCI Intl. Momentum Factor ETF (NYSEARCA: IMTM),
- iShares Edge MSCI Intl Value Factor ETF (NYSEARCA: IVLU) and
- iShares Edge MSCI USA Quality Factor ETF (NYSEARCA: QUAL).
The factor-allocation of the Smart Beta World-portfolio looks like this:
The biggest factors remain Quality, Momentum and Low volatility.
Compared to the previous portfolio-composition the weight of Low volatility is increased to the detriment of the allocation to Size and Momentum.
The 10 biggest countries in the Smart Beta World-portfolio are:
The portfolio is heavily underweight the United States given the lower expected returns. Because of their higher expected returns, the developed markets ex-US and the emerging markets are overweight. The overweight of the latter is less outspoken due to the higher volatility they exhibit.
The lower expected return for US and emerging stocks and the higher expected return for international stocks is reflected in the new regional allocation.
When we look at the Smart Beta World sector allocation, we can see:
- an overweight position (compared to the MSCI All countries) in Financials and Industrials, and
- an underweight allocation in Energy and Technology.
Smart beta strategies like Quality, Value, Momentum, Low volatility and Size have historically outperformed market weighted indices. But all those strategies or factors have experienced significant drawdowns and often long periods of underperformance. The low correlation between these factors suggests that combining them can offer substantial diversification benefits. We propose smart beta portfolios that favors those factors that are cheap versus their own history.
The Smart Beta World-portfolio is heavily underweight the United States given the lower expected returns. Because of their higher expected returns, the developed markets ex-US and the emerging markets are overweight. The overweight of the latter is less outspoken due to the higher volatility they exhibit. The biggest factor-allocation is Quality.
For US-centric investors that can't overcome their home bias and want to invest in just one factor-ETF, we advise to buy the iShares Edge MSCI USA Quality Factor ETF (NYSEARCA: QUAL).
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This article provides opinions and information, but does not contain a recommendation or personal investment advice to any specific person for any particular purpose. The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.