The Key to Smarter Investing: Smart Beta ETFs

As an advisor, you’re well aware of the value of ETFs. These versatile investment vehicles can provide your clients with tax-efficient exposure to specific areas of the market. It wasn’t long ago that ETFs shared another common trait: they were passively managed. Designed to closely replicate the performance of a market index, most ETFs used a market cap-weighted approach that gave larger companies a higher weight in the index, and smaller companies a lower weight. But recent innovations have delivered a whole new family of ETFs called Smart Beta.

Unlike traditional ETFs, Smart Beta ETFs use a different approach to indexing—one that helps bridge the gap between active and passive investing.

Smart Beta ETFs are similar to active strategies in that they seek to take advantage of current market opportunities. At the same time, they adhere to a rules-based, transparent approach that looks very similar to traditional passive funds. It’s an attractive combination. It’s no wonder the number of Smart Beta ETFs is increasing nearly every day. According to London-based research firm ETFGI, Smart Beta ETFs saw net inflows of $71.75 billion in 2017, and Bloomberg reports that ETF Assets Have Grown an Average of 15% a Year since 2012.

Factors: The Foundation of Portfolios

Factor investing is one approach that is widely used by this new generation of ETFs to seek potential outperformance of a broad index, while remaining passively managed. Using this approach, securities are selected based on attributes associated with having an objective toward achieving a specific result or risk-adjusted return—essentially the forces behind what drives returns of stocks, bonds, and other assets over time. Of course, it’s not a new concept. Factors are rooted in the very foundation of the Capital Asset Pricing Model (CAPM), dating back to the mid-1960s. And the use of factors has grown in its sophistication since those early days, and today, factors are used in Smart Beta ETFs to help take portfolio optimization to a whole new level.

Factor-based ETFs seek to isolate different performance characteristics to target specific results, or combine factors to optimize a portfolio. The goal: to find potential to outperform the broader market by tracking indices constructed around one or more factors.

The six most commonly recognized factors include:

Momentum seeks to isolate securities that see acceleration in their price or volume. This factor seeks to take advantage of the continuance of an ongoing trend in the market.

Low Volatility seeks to isolate securities with low-trailing volatility for a given period—in other words, the prices of these securities tend to move less.

Size seeks to isolate overlooked companies with smaller market caps, which may provide higher returns than companies with larger market caps.

Value seeks to isolate cheaper securities, which may generate higher returns than more expensive stocks.

Quality seeks to capture excess returns for securities that are characterized by low debt, stable earnings growth, and other “quality” metrics.

Dividend Yield seeks to capture excess returns for securities that have higher-than-average dividend yields.

Single-Factor and Multi-Factor: Choosing the Approach for You

Whether you choose to use a single-factor approach or a multi-factor approach depends on your investment goals. The single-factor approach is commonly used to “tilt” a portfolio’s holdings toward one specific factor to change the risk/reward profile of the portfolio. For instance, clients with well-rounded portfolios may only want some additional exposure to a specific factor—which can be tactically increased through a single-factor ETF. In contrast, clients with little to no exposure to any factors may be best served by a multi-factor ETF that incorporate two or more factors to provide broader coverage.

Related: 5 Things to Watch in the U.S. Equity Markets in 2018

The Cyclical Nature of Factor Performance

Clearly, both approaches can play a significant role in a portfolio. Whether using a single- or multi-factor approach, it is important to note that factor performance is cyclical in nature—which means that no one factor is consistently more favorable than any other. Since each factor can potentially outperform or underperform the market in any given period, diversification continues to play a key role in factor investing.

Consider Smart Beta as Part of Your Investment Plan

As demand for ETFs increases and factor investing continues to enhance diversification potential by helping reduce the correlation between investments held in a portfolio, you may want to consider Smart Beta ETFs. Whether you choose a single- or multi-factor approach, these innovative tools can help you bridge the gap between active and passive investing to address the ever-changing needs of your clients.

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1Source: MSCI Foundations of Factor Investing.
2Source: Morningstar, 12/31/17.
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