There are a large body of research shows that a only a small number of funds after fees beat the market over the long run. It has become common knowledge that investors should just track the market by buying index funds.
The first index fund portfolio were constructed using size (commonly market cap) as a key metric which determines the weight of stocks in the index. The larger the company, the greater portion of the index the stock will consist in the index.
There are a number downside from just using market capitalization as proxy for portfolio weights.
- Large companies by law of large numbers it is usually harder for them to grow faster than smaller 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.
Even with the points above the simplistic approach is one of main factors which made index fund so successful. It uses survivorship bias to its benefit as exposure to stronger companies increases overtime as they become more successful while weaker performing stocks are automatically trimmed from the portfolio. It is really an implicit strategy of just constantly buying winners.
But choosing stocks just based on their size is not without its flaws. Overtime it can lead to overly concentrated portfolio even if the portfolio is nominally diversified across set number of companies.
For example the ASX 200 large cap index includes 200 largest listed Australian companies. However the banking and mining sectors dominate more than 50% of the index. Similarly looking at it from another way the top 10 positions in the fund can make up to half of the fund as well with an overt concentration to the big 4 major bank shares. It can be argued that there is limited benefit from owning all of the big 4 banks as given their size and position in the market, they are essentially exposed to the same set of macroeconomic risks (gold coast property prices), business and credit cycles.
What is smart beta ETF?
Smart beta ETF is the next set of evolution in listed ETF space. Unlike traditional index funds such as S&P 500, DAX or FTSE in which the primary criteria for inclusion in the index and its make up is the company market capitalization. Stock selection in the smart beta ETFs are based on investment factors hence smart beta investing is also known as factor investing.
These new generation of ETFs were designed to be at the intersection of index tracking ETFs and actively managed funds. It has the best of both worlds matching the positive features of ETF investing such as low cost and transparency with degree of flexibility of strategic security selection seen in active management. The portfolio creation is based on historical tests of specific factors which shows greater source of returns or lower volatility for a set of return profile.
Example of factors include price to book ratio, price to earning ratio, dividend yield, balance sheet ratios such as low leverage companies or other investment characteristics that make up value or growth stocks. Similarly to dividend exchange traded funds, there are buyback ETFs where the portfolio makeup is based on companies with outstanding buyback programs. The selection of factor makes them a tad closer to active ETF than traditional passive investing the sector is known for.
Active management in the context of smart beta does not necessarily mean there is a fund manager picking stocks within the smart beta fund. Rather the funds is created by a predetermined rules in deciding what kind of stocks goes into the index.
Investing through 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.
Similarly it a bid to bypass the weakness of traditional ETFs, some funds avoid concentration risk by simply nominate all positions to have same weight at each rebalance period.
Smart beta ETF List
We have to caution that some funds are created by simply data mining the historical returns and reverse engineered what worked in the past and extrapolating into the future.
Past performance is not an indication of future performance. Only because a portfolio using these factors has performed well in the past does not mean it will work in the future. All investment should be made using judgement and logic.
Our investment approach is always look if the current trading price reflect the fundamental value. If it is overpriced given the risk, we will pass and wait for the next pitch.
Examples of Smart Beta Strategies
Equal weight ETF – Equal weight strategies means exactly as it sounds. The weight of companies are the same and the fund is rebalanced quarterly. For example every stock in the ETF is weighted 0.25% and as long as the stock is included in the underlying index it will be included in equal weighted fund. This is a more mean reversion approach to portfolio management such that winners as sold and losers are bought to the same position at fixed intervals.
Volatility Constant ETF – Another smart beta approach is through reweighing the exchange fund holdings by volatility. The weight of individual positions are based on the underlying volatility of the stock, whereby higher volatile stocks have reduced impact on the portfolio and inversely the portfolio will be overweight lower volatile stocks.
This strategy is designed to provide a more stable portfolio while maintain growth exposure. The thesis is that returns are not everything in investing. A volatility constant ETF tracking an index allows investors exposure to an index with minimal volatility position.
Stock Buyback ETF – These are funds which select stocks that has ongoing or historical track record of implementing a buyback program covering more than 5% of the outstanding shares. Creation of Buyback ETF is based on the research which shows companies undertaking buybacks outperform its peers following announcement of buy backs even after 12 months. Buyback ETFs can be further segmented by funds focusing on US companies or international companies only (Japan or UK).
Dividend ETF – An investment portfolio which weights companies in the portfolio based on the history of dividend growth and yield. Dividend funds are designed to target income driven investors with a higher risk tolerance than fixed income investors. Investors need to be aware that the higher yields of dividend ETFs vs Bond ETF is because investors are still taking on equity risk rather than credit risk which is more secured position in the companies capital stack.
Smart Beta Bond ETF
The above examples of smart beta or factor ETF does not only apply to equities. The same strategies can be adopted for fixed income asset class.