Understand the Ins and Outs of Smart Beta ETFs

Understand the Ins and Outs of Smart Beta ETFs

As the smart-beta segment becomes a significant force in the exchange traded fund space, ETF investors should understand how the indexing structure works and the potential benefits of utilizing the investment strategy.

In a recent Charles Schwab note, Anthony B. Davidow, vice president for alternative beta and asset allocation strategist at Schwab Center for Financial Research, pointed out that there is nearly $400 billion in assets in smart- or strategic-beta ETFs.

Leading the space of smart-beta funds, Research Affiliates Fundamental Index strategies are home to roughly $140 billion in invested assets.

Rob Arnott, chairman and co-founder of Research Affiliates, argues that the rapid growth is attributed to investors’ desires for alternative indexing methodologies that did not follow traditional market-capitalization weights.

“It made no sense that an investor in a cap-weighted index would inherently have his greatest exposure to a company precisely when it was most expensive,” Arnott told Schwab. “That entire construct runs completely counter to the basic axiom of buy low, sell high.”

Consequently, through back testing, Research Affiliates found that rebalancing away from market-cap generated excess returns, notably greater excess returns in U.S. large-caps and even greater returns in less efficient markets like small-caps and emerging markets.

“Rebalancing works!” Arnott added. “It works across time periods. It works across geographies. Routinely selling the most loved companies (“popular” stocks) and buying the most loathed (“underappreciated” stocks) generates excess returns over a cap-weighted index that assigns company weights based solely on popularity.”

Given the large number of smart-beta strategies now available, investors should understand how the ETFs’ underlying indices are constructed and the specific characteristics that they exhibit. For instance, RAFI equity strategies weight companies based on fundamental measures, such as adjusted sales, cash flow, dividends and buybacks.

The PowerShares FTSE RAFI US 1000 Portfolio (NYSEArca: PRF), which tracks a Research Affiliates index, is one of the longest running smart beta ETFs on the market and will hit its 10th anniversary in December.

Once an ETF methodology is understood, it is up to the investor to determine where a smart-beta ETF fits in with an overall investment portfolio. Most broad smart-beta ETFs, like RAFI strategies, may help investors generate attractive long-term, risk-adjusted returns. Additionally, the amount exposure would depend on one’s risk tolerance as some of the holdings may be contrarian to an investor’s overall outlook. [Index ETF Investors Should Better Understand Their Benchmarks]

Potential investors should also understand that these strategies work well under a long-term horizon and short-term volatility may cause under or outperformance.

“Our own Jason Hsu and John West have written separately on the importance of not only identifying outperforming strategies but keeping them during the inevitable periods of underperformance,” Arnott said. “No strategy works all the time; if we chase what’s worked recently and drop whatever has been disappointing, we can undo the benefit of all our hard work identifying superior strategies.”



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