Smart Beta ETF sector is one of the fastest growing trends in exchange trade funds space. Smart beta exchange traded funds has seen double digit growth in asset under management
Smart Beta ETF Vs Index Funds
Traditional passive index funds are constructed using the market capitalization of the companies relative to each other. For example in market cap indexes like Russell 2000 Index or the Hang Seng Index, HSBC is not only the largest bank but also make up one of the largest constituent in the Hang Seng index.
The performance of the market cap based indexes by its nature is biased towards larger stocks and thus present a huge flaw if used as a proxy for weights.
- By law of large numbers, large companies usually grow slower than smaller companies. Therefore current market cap weighted ETFs are on average 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.
Smart Beta ETF Examples
The development of Smart Beta ETF was aimed to create 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 ETF.
Smart beta funds are separated into distinct strategies including securities formed in a portfolio on a equal basis (equal weighted funds), volatility weighted strategies, dividend income focused funds or a portfolio of stocks which has a buyback program in force.
Active management in the context of smart beta exchange traded funds does not necessarily mean there is a portfolio manager picking stocks. Instead the portfolio are constructed using a set of predetermined rules.
The Smart Beta ETF list created below are some funds that were created as result of the intersection. These funds aims to have the best of both worlds in matching the positive features of ETF investing such as its low cost and liquidity with degree of flexibility using factors which has historically being a driver of returns similar to stock selection in active management.
At the end of the day investing in 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 the pre set rules.
iShare Smart Beta ETF
iShares created a specific family of smart beta exchange traded funds with an emphasis on 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
The underlying securities holdings have 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. Tech companies by nature 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. ROE is calculated using book value 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 focused smart beta ETF. The aim of the fund is screening stocks using the value factor fundamental and only choose stocks which are considered “low valuation”. The downside of this approach is it is susceptible of buying into value trap companies where stocks are priced on a low valuation for a reason due to the underlying business being permanently impaired.
iShares MSCI USA Size Factor ETF (SIZE) and iShares MSCI USA Momentum Factor ETF (MTUM) aim to construct an ETF based on size (small companies) and price momentum.
Dividend Factor ETFs
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 companies in the 500 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 which 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.