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ETFs 101: A Guide To Smart Beta


The concept of "smart beta" strategies in the ETF industry is still a bit of a mystery to many investors.

How "smart" is smart beta really?

I offer my choices for some of the best smart beta ETFs currently out there and how you can work them into your own portfolio.

Note: This is the second article in my "ETFs 101" series where we get back to the basics of how to analyze ETFs and build portfolios using them. The first article, titled "ETFs 101: My Basic Criteria For Choosing An ETF", talks about all the factors I consider when selecting an ETF for my own portfolio. One commenter called it:

One of the best articles written about ETFs on SA that I have ever seen. A must read for investors in this space.

If you're interested in how I apply these principles in our model portfolios, ETF rankings and real-time ETF recommendations, please consider joining me for a FREE TRIAL of ETF Focus. Through the end of 2018, you can also receive 20% OFF of your first year's subscription cost AND lock in current rates before the price goes up on January 1st! Click HERE to learn more!


Earlier this year, I travelled down to Orlando to take part in a smart beta panel with Eric Balchunas, the senior ETF analyst for Bloomberg News, and Luciano Siracusano, the Chief Investment Strategist with WisdomTree. The Friday 6PM slot that we were given wasn't the hottest time to conduct a deep discussion on ETF investing (especially considering they were getting ready to open up the bar!), but we had a great crowd nonetheless!

One thing I was struck by was the sophistication level of the investors that showed up to the event. Despite the rapid growth in ETF assets over the past two years, smart beta was still a bit of a mystery to many. It was an especially opportune time to educate on ETF investing considering the swift correction that had taken place in February and is still occurring today!

If you're not entirely familiar with what smart beta is, how it works in practice and how to implement it in your own portfolio, you're not alone! This piece is designed as a great primer to get you up to speed covering the most basic of questions all the way up to the best way to use smart beta strategies in your own portfolio! If you want to continue the discussion or have any questions, jump on the comment thread below!

What is smart beta?

Let's start with the most basic question first!

At its core, smart beta could be described as any alternative weighting or index construction methodology that differs from a traditional market-cap weighting strategy. For example, take a fund, such as the SPDR S&P 500 ETF (SPY), that market-cap weights its portfolio. Smart beta offerings using the S&P 500 would include the following:

  • Invesco S&P 500 Equal Weight ETF (RSP)
  • Reverse Cap Weighted U.S. Large Cap ETF (RVRS)
  • SPDR Portfolio S&P 500 High Dividend ETF (SPYD)
  • Invesco S&P 500 Low Volatility ETF (SPLV)

You probably get the picture. Smart beta takes a traditional index and tilts it in a way that emphasizes a strategy that has historically managed to perform well in the past. It takes this strategy, develops a rules-based stock selection process around it and puts it on autopilot. What you end up with is a product that is thought to provide the best aspects of both active management and passively-managed index funds. It provides the opportunity to outperform the market over time while charging an expense ratio far below what you'd find in a traditional actively-managed fund.

There is, however, no real universal definition for smart beta. While most of the ETFs listed above would generally be accepted as smart beta strategies, some would consider a plain vanilla value or growth fund as "smart beta" as well.

How "smart" is smart beta?

In reality, the label of "smart" is a bit of a misnomer. There's nothing inherently smart about a smart beta strategy other than the fact that, in many cases, it's performed well in the past on either an absolute or risk-adjusted basis.

I think they're probably more accurately defined as "alternative beta" or "strategic beta" strategies. Market-cap weighting, equal-weighting, volatility-weighting, etc. will sometimes outperform the others depending upon the market environment. It doesn’t necessarily make one strategy smarter than another, but they do provide investors with different options, which I think is a good thing. Some of these alternative strategies are backed by better evidence than others, and some are backed by better results, but the idea that a low volatility ETF is somehow smarter than a plain vanilla S&P 500 ETF is a bit misleading.

There are other products that I would prefer to instead label as different or opportunistic. Now, I’m going to try to say this as apolitically as possible, but the Point Bridge GOP Stock Tracker ETF (MAGA) is a great example. This fund chooses companies based on how much the company or its PACs donate to Republican causes and campaigns, and then equal weights them. How much money a company donates to political causes has nothing to do with the fundamentals or financial strength of a business, so investing in MAGA is almost like throwing darts against the wall. A product like this will no doubt appeal to folks who want to align their political views and their investment goals, but there's no evidence that this strategy is in any way predictive in nature.

What are some popular smart beta strategies?

These can be broken down into two general categories: alternative-weighting strategies and factor-tilt strategies.

Many of the most popular alternative-weighting strategies were covered earlier. In addition to those, there are several Oppenheimer ETFs (soon to be Invesco ETFs) that are revenue-weighted, such as the Oppenheimer S&P Ultra Dividend Revenue ETF (RDIV). One of the beefs with market-cap-weighting is that some companies can develop huge market-caps without offering much in the way of revenue or earnings. Tesla (TSLA) would be a good recent example of this. Revenue-weighting is a nice alternative to market-cap weighting because it takes some of the market sentiment out of the equation. Using sales as a measuring stick gives a steadier and more accurate read on who the biggest and most successful companies generally are.

In addition to those, there are five commonly used factor-tilt strategies - momentum, value, low volatility, size and quality. Momentum, which works on the premise that you should let your winners run, is arguably the most popular of the bunch although low volatility is probably not too far behind. Quality can look at any number of factors, but generally focuses on ROE, ROA, profitability and cash flows. The size factor targets smaller companies, while value goes after cheap stocks.

You can find ETFs that focus on both single factors and multiple factors. The USAA MSCI USA Value Momentum Blend Index ETF (ULVM), for example, looks for the best combinations of these two factors, while the iShares Edge MSCI Multifactor USA ETF (LRGF) considers all of the major factors.

Do smart beta ETFs really offer the best of both active and passive?

I think so. We know the benefits of broad-based index funds. They’re really cheap, they’re tax efficient, they give broad diversification in one simple product. They belong as the core of most portfolios. Smart beta ETFs give you the ability to tilt your portfolio in a way that’s still relatively inexpensive and it’s transparent - you know the type of strategy you’re buying. Many active funds have the broad mandate that their goal is to “outperform the S&P 500” or “deliver regular monthly income”. In a lot of cases, it’s kind of a mystery what the manager is doing to achieve that, and, since the portfolio holdings may only be updated on a monthly or quarterly basis, you may not even know what you own at any given time. With smart beta, if you buy a fund like the SPDR S&P Dividend ETF (SDY), which invests in the highest yielders of the S&P 500, you know what you own, and you have a sense of how it’s going to impact your overall portfolio. If you own a portfolio that's heavy in utilities and consumer staples, you know that SDY is going to exacerbate that exposure. Smart beta ETFs help provide a degree of transparency and lower cost that a lot of active funds currently don’t offer.

And they're continuing to get cheaper, which is always a good thing!

Should smart beta ETFs take the place of active funds or traditional market-cap-weighted index funds in an investor’s portfolio?

In the sense that smart beta is a better version of actively managed funds, I think the answer is yes. Traditional active management bets on the stock picking abilities of the manager in charge. Given that the average actively managed fund charges 50 basis points or more (or in the case of actively managed mutual funds, 100 basis points or more), an active fund has two disadvantages. One, the manager has to be able to deliver alpha due to his own stock picking ability, and, two, he has to be able to deliver enough alpha to outweigh the higher expense ratio. If the manager can’t do that, investors will be better off in lower cost index funds. History has shown that 80-90% of active managers are unable to keep up with their benchmark over time, so that’s a tall order, if not impossible, to be able to find an active manager who can beat their benchmark consistently. Smart beta presents a better alternative because a) fees are generally lower than active funds, and b) you’re able to tilt your portfolio in a manner where you know what you’re getting.

I don’t have an issue with market-cap weighting, per se, but it does weigh heavily towards the biggest companies in a way that you may not want. Investing in the S&P 500 sounds great on the surface, but 25% of the index is concentrated in about 10 companies. Equal-weighting provides a great alternative if you still want to own the 500, but spread out the risk a bit. I think volatility-weighting or dividend-weighting are great options if you’re looking for a more conservative equity fund or a higher yielding fund, but I wouldn’t automatically dismiss market-cap weighting as a viable strategy.

Smart beta strategies come in many different flavors, including dividends, low volatility, value, momentum, quality, and multifactor ETFs. How can investors determine what types of smart beta strategies make sense for their portfolios?

Investors first need to understand what they’re comfortable with and what they’re objectives are. If you’re risk-averse, then a low volatility strategy might make sense. If you’re retired and looking to your portfolio to generate income, then a dividend-weighted or a value strategy might work. Now, investors will probably still want to mix some other strategies in there to balance out risks. The Invesco S&P 500 High Dividend Low Volatility ETF (SPHD), for example, is a great fund with a great long-term record, but it seriously underperformed in 2017 because investors only wanted growth and momentum names. So I think you still need to blend a mix of different smart beta strategies in some combination, but the core of those investments should be consistent with your most overarching objective.

Here's where it gets tricky though. Using a smart beta strategy can have some unintended consequences. If you own the SPDR S&P 500 ETF (SPY), you know you're getting a portfolio heavily weighted towards mega-cap names. If you choose to go with the Invesco S&P 500 Equal Weight ETF (RSP) instead, because you've read that this strategy outperforms the S&P 500 over time, suddenly your mega-cap fund looks and acts more like a mid-cap fund. You've now likely tilted your portfolio away from a low volatility strategy. Even a typical annual rebalancing strategy, in which you're essentially selling winners and buying losers introduces more of a value tilt, and moves you away from a momentum strategy, which would tell you to let those winners run. All of these little moves add up, and it's important to give your full portfolio a look to make sure it's set up the way you want.

What types of smart beta strategies are likely to offer higher returns over the long run?

The nice thing about a lot of these funds is that even though the fund may have only been around for a few years or so, the underlying indices, in many cases, have been around a lot longer and during a lot of different market cycles. Or they’ve been backtested many years into the past. Using SPHD as an example again, the fund launched in 2012, but the S&P Dow Jones website has index data going back to 1990. And you can see during the past 25+ years, the index has beaten the S&P 500 and has done it with far less volatility. So that’s a strategy that you can say has worked over a period of almost three decades, and draw the conclusion that it could have a good chance to outperform over the next three decades. Of course, who knows if that’ll actually happen, but I think you can use history as a guide. We know that dividend payers have traditionally outperformed non-dividend payers. Value has traditionally outperformed growth. Funds with low expense ratios tend to do better than ones with high fees. Obviously, you have no way of knowing what’s going to do the best in the future, but I think history can sort of guide us in how to tip the scales in our favor.

I think one saying is pretty appropriate here - "if it were simple, everybody would be doing it". In other words, just because a strategy has worked well in the past doesn't mean it will continue to work going forward!

What types of strategies are better for more defensive investors?

I’ll answer that question in two different ways. First, investors can choose to invest in traditionally defensive sectors, such as utilities or consumer staples - sectors where product demand is constant - or Treasuries, if you want to get away from equities altogether. Of course, that strategy presents its own challenges, because in economic environments, such as this one, where the Fed is expected to potentially continue raising rates, rate sensitive sectors might not be the best place to be. So, your other strategy would be go after a quality factor tilt, which targets companies in strong financial condition, with healthy balance sheets and solid cash flows. These companies aren’t necessarily sexy names like Tesla (TSLA) or Netflix (NFLX), but they’re companies that have the financial strength to whether an economic downturn.

One option is the iShares Core High Dividend ETF (HDV), which uses Morningstar’s Economic Moat and Distance to Default scores to choose companies, and then picks out the highest yielders in the group. Another option is the FlexShares Quality Dividend ETF (QDF). It takes a similar approach by looking at balance sheet data, such as profitability and cash flows, to identify companies with the highest dividend strength, and then also chooses the highest yielders. Or if you wanted to target the quality factor, specifically, you could choose the iShares Edge MSCI USA Quality Factor ETF (QUAL).

Another option (although not necessarily a smart beta strategy) is the Pacer Trendpilot U.S. Large Cap ETF (PTLC). It rotates into equities when the S&P 500 is above its 200 day moving average and into Treasuries when it falls below that line (there's a little more nuance to PTLC's strategy, but that's generally what it looks to do). Its goal is to stay invested when the trend is up but get out of the market when things begin turning south. It's a nice, although somewhat expensive, option if you want some downside protection in a rules-based format.

Even within a given investment style, there are many competing smart beta ETFs with similar names that often look and perform quite differently from one another. How should investors decide among seemingly similar funds?

I covered this in a previous blog post where I talked about how important it is to know what you're investing in and to understand the differences between products that appear very similar on the surface. I'd encourage you to read that post as I run down the differences in pairs of biotech, emerging markets and momentum ETFs.

This is where an investor needs to do their homework. A lot of strategies look the same on the surface, but it’s often just subtle differences that distinguish them. The ProShares S&P 500 Dividend Aristocrats ETF (NOBL) and the SPDR S&P Dividend ETF (SDY) are good examples. Both focus on the dividend aristocrat universe, companies that have long histories of paying and increasing their dividends. NOBL looks for companies with 25 years of dividend raises. SDY only requires 20 years. NOBL equal-weights. SDY dividend-weights. They seem like subtle differences, but NOBL has outperformed SDY by 8% over the past year, so these little distinctions can yield big differences in results. And if the differences appear too subtle, look at the expense ratio. In most cases, cheaper is better.

Are there any red flags investors should watch out for?

I mentioned the idea of gimmicky schemes already. I’d come back to fees again, and I'm not just talking about looking at the expense ratio, although that's very important, of course. I'm referring to the bid/ask spreads that often come from trading in newer and smaller funds.

A new fund may have the best strategy in the world, but if it has only $5 million in assets, or trade only 1,000 shares a day, you’re probably going to get killed on spreads. If you're one of only a few that wants to trade in a fund, you're probably going to need to pay a premium to find shares to buy, or sell at a discount in order to find a buyer for your shares. Spreads can be one of the most dangerous things for investors.

Consider a fund, such as the Franklin FTSE Canada ETF (FLCA). It's got an expense ratio of just 0.09% making it one of the cheapest international equity ETFs around. You may look at that and think that FLCA has the green light for trading, but look below the surface. FLCA has just over $3 million in assets and trades less than 1,000 shares daily. The spread on FLCA is frequently above 0.25%. Add those two percentages together and suddenly that really cheap expense ratio doesn't look quite so cheap when all costs are added in. The ETF's expense ratio is obviously important, but always take a look at total costs before pulling the trigger on a trade.

How should investors set realistic expectations for their smart beta ETFs? Are back-tests representative?

No backtest is going to be perfect, but I think they can be directionally correct. I wouldn’t put too much weight into it though, because every index that’s been created probably has good backtest results, otherwise they wouldn’t have created the index in the first place. But something like SPHD, which takes the 75 lowest volatility stocks and then takes the 50 highest yielders from that group, is a combination of two themes that have generally played out over time - value, the group in which many low volatility stocks fall, outperforms growth and dividend payers tend to outperform non-dividend payers. SPHD puts a little twist on that by choosing the highest dividend payers, but the backtests show that this strategy has worked too. So we’ve got a fund. It doesn’t mean the fund will outperform going forward, but it helps you make an educated guess instead of just a guess.

How worried should investors be about smart beta ETFs losing their efficacy as they become more popular?

I think there’s always a risk of investors piling into a group trade only to have it blow up down the road. I think the concern is that passive investing is ruining active management. Instead of selecting stocks based on fundamentals or valuations, people are just piling into indexes and buying the same stocks without regard to whether or not they make sense, or whether or not they present an attractive opportunity. Pretty soon valuations get out of whack and then the law of averages takes over.

I think some of that is justified, but I look at this question also from a standpoint of how big the ETF market is relative to the markets as a whole. Keep in mind that ETFs account for just 7% of all equities currently, so anything that happens within the ETF marketplace will only move the needle so much in the big picture.

To be honest, I’d be more worried about the abundance of leverage available to investors nowadays. We’ve seen the market pullback 10% in relatively short periods of time on multiple occasions this year. In January/February's correction, that was thanks to some of these volatility-focused ETPs blowing up. We’ve seen flash crashes in the past that have dropped some ETF share prices by 30% for a few minutes (although that wasn't necessarily volatility-driven). It’s some of these tail risk events that have me worried far more than ETFs losing their effectiveness.

Even the best smart beta strategies can go through extended stretches of underperformance. To what extent can investors reduce their risk of underperformance by diversifying across different smart beta strategies?

This is the basic diversification argument that says when investors own multiple asset classes it helps reduce the risk of the portfolio as a whole. In this case, tilting across multiple strategies could be helpful.

I’ll use SPHD as an example again. It’s had a great run since its inception but it did very poorly in 2017. That’s because investors saw a good economy, low unemployment, low rates and only wanted growth and momentum names. Plus, the whole market was essentially one big low volatility ETF, so there was little benefit to managing towards that factor strategy. If, for example, you have a low volatility fund, a dividend fund and a growth-weighted fund, then you can still take advantage of some of those factor benefits, while smoothing out the ride.

You could diversify your risk by investing in several single factor funds or a multifactor fund, such as the iShares Edge MSCI Multifactor USA ETF (LRGF), could do the trick too.

Is it more effective to own a few smart beta ETFs that each target a different factor, like value or momentum, or go with a single multifactor fund?

Generally speaking, I’d stick with a multifactor fund over single factor one. I like a fund, such as LRGF, because it manages all of the major factors with respect to each other. It scores companies on the momentum, size, quality and value factors, and runs them through a model to pull out the companies with the highest composite score. I like this approach, because it gives you exposure to some of those factor tilts, but helps smooth out some of the volatility because you’re not going to be overweighted to any one particular factor. The single factor ETFs involve a bit more market timing and skill because you have to decide if value is going to outperform growth or small-caps are going to outperform large-caps. Since investors and money managers are generally not good at timing, there’s a better chance of underperforming there. I don’t think there’s anything wrong if you want to overtilt with a little bit of your money, but I wouldn’t make single factor ETF tilts a core strategy.

Up to this point, we’ve been talking about equity smart beta ETFs, but do smart beta funds also make sense in the bond world?

Bond investing tends to be more complex, and bond managers have earned a reputation as pseudo-wizards who can understand what no one else can, so there's some reluctance to move away from that model. Bonds tend to be more complicated because you have to deal with spreads and durations and rate curves and all of these factors that make them challenging to analyze. There's some evidence that a value tilt works in fixed income, but it’s going to be more challenging because I don’t think we have a good grasp on what makes for a good smart beta strategy. Plus, transaction costs will kill you if you try to establish a diversified bond portfolio on your own. If a company, such as Vanguard, can give you a bond portfolio for pennies, the preference is probably there. So, I think they can make sense, but I think we have more work to do to make them more efficient.

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Disclosure: I am/we are long QDF,SPHD.