With such a large number of smart beta ETFs options now available, writes Hoshang Daroga, it is important to have a selection process and objective clearly defined before using them to build portfolios
Over the past decade, exchange-traded funds (ETFs) have come a long way. Originally just a simple way to track a market, they can now track a broad range of indices using alternative - non-capitalisation - weighting schemes. More active in nature, this next generation of funds are more popularly known as ‘smart beta ETFs'.
Smart beta is a broad term used to describe ETFs that track indices in which securities are not weighted based on market capitalisation. Instead the weighting scheme is based on certain characteristics known as ‘factors', such as size, value, quality, volatility, momentum and dividend yield. Smart beta ETFs can therefore be thought of as funds that invest in securities based on some investment merit and not simply because they are large in size.
Interestingly, these factors are the same characteristics that are traditionally used by a number of active managers to outperform the market, such as value investing. As such, smart beta can bring a more active style of investing to the index-tracking market in a rules-based, transparent and relatively cost-efficient manner.
Smart beta has gained tremendous popularity with a large number of new launches in the past few years and is now more frequently included when constructing model portfolios. The recent launch of Copia smart beta models using First Trust Global Portfolios and Dorsey Wright have proved to be successful when it comes to beating their comparators.
In today's markets, there are not only an abundance of single-factor ETFs but also a large number of ETFs that combine multiple factors into one. With such a large number of options, it is important to have a selection process and objective clearly defined before building portfolios using them. Since smart beta ETFs are alternatively weighted strategies, they can fit very well in a ‘core-satellite' portfolio construction framework.
Selecting smart beta ETFs is no easy task but there are three core ideas that should be kept in mind:
* Factors should be backed by academic theory and empirical evidence.
* Factors should be persistent - in other words, will they behave the same in the future?
* Factors should be diversified.
At Copia Capital Management, we believe value and momentum are the strongest and most persistent factors that deliver a risk premium over the longer term with relatively low to negative correlation. These two factors have been researched extensively by the academic community and have also been widely used by the asset management industry.
Value: Value investing is arguably one of the oldest forms of investing used in financial markets. It is where a manager selects stocks that trade for less than their intrinsic values. Today, we can gain exposure to this same style through smart beta ETFs that select value stocks in a systematic rules-based format.
Momentum: Momentum investing has been used heavily by a number of active managers and is primarily based on the belief that trends exist in financial markets and one can outperform the market by investing in stocks that have upward trending prices.
The momentum anomaly continues to persist as investors have an inherent tendency to be part of a larger crowd and participate in stocks that have achieved strong past performance. This leads to trends in stocks prices that can act like a ‘self-fulfilling prophecy'. Technology stocks are an example of this.
A core satellite approach to constructing portfolios can be used in two ways:
* Application to entire portfolio: A large ‘core' portion of the asset allocation can be achieved using traditional market-cap based ETFs. This can be enhanced by having a ‘satellite' of smart beta holdings. This method is typically used by asset managers running specific mandates.
* Split mandates: This is more typical when investors aim to diversify manager risk by using multiple managed portfolios. A large ‘core' portion of the full investment amount is placed in a strategic asset allocation either run by a manager or built with traditional market cap-based ETFs.
Separately, a ‘satellite' smart beta portfolio helps to capture additional alpha through different factor risk exposures not available from traditional investment options. This method is typically used by financial advisers as they look for ways to diversify manager risk as well as capture uncorrelated performance.
Portfolios of smart beta ETFs are a great way to gain or mitigate exposure to certain risk factors and help in the construction of portfolios with alternative risk/return characteristics. Such portfolios fit very well in a core-satellite framework by providing manager and strategy diversification benefits to the investor. In this respect, they can complement, rather than replace a traditional investment approach.
Hoshang Daroga is a quantitative investment manager at Copia Capital Management
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