Best yet, these factors have performed even better in down years. Over the last 21 years, the MSCI All-Country World Index has had a negative return in six of those years. In each, the average factor has been higher for the year. The average excess return in those years was +4.6%.
Understanding smart beta is important, so we wanted to address some of the most commonly asked questions we get about it. Here are the top 10.
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What is the difference between smart beta, strategic beta, intelligent beta, alternative beta, and factor beta?
Nothing! Those terms all mean the same thing.
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How do you use factors in your portfolios?
We use factors in three key ways.
- For security selection. Factors have worked over time, and we expect they will do the same moving forward.
- For better understanding portfolio risk and return drivers. Factors, compared to traditional economic sectors, tend to be more stable in their return and risk characteristics. In addition, using factor analysis as a risk management tool helps identify unintended risk exposures that traditional portfolio-based analysis would have missed.
- For explaining to investors how markets work and how a thoughtful approach to building portfolios can potentially lead to better long-term results. It’s a better discussion than who the next Federal Reserve chair might be or how high-frequency economic data might impact the markets.
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How popular is smart-beta investing becoming?
FTSE Russell recently released its 2017 global survey on smart beta usage, pointing that usage has doubled over the last two years among the institutional investors surveyed. That growth is being led by Europe. Usage is increasing due to more offerings and more education.
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Where are allocations coming from?
The FTSE Russell survey showed most allocations in the industry are due to investors moving from actively managed funds into smart beta. At CLS, however, we take allocations from vanilla, cap-weighted ETFs. In this case, we might be paying more – perhaps 15–20 basis points (bps) more – but, since factors have added more than 200 bps a year for the last 20 years on average, we think paying up a little is definitely worth it.
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Aren’t smart beta ETFs basically just “quant” funds?
Yes. But, smart beta ETFs have a simpler and more transparent investment approach, which is easier for investors to understand than traditional quant funds.
The advantage of quant funds was their discipline, but their weakness was they were usually a black box, managed with a secret and “magical” formula. Smart beta ETFs, meanwhile, are transparent, tested, and much easier to understand.
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How do you do due diligence on factor-based ETFs?
It is important to understand the underlying methodology and holdings of smart beta ETFs. Due diligence boils down to examining the expected return and risk characteristics. For us to calculate the expected return of any ETF, we need to drill down to the underlying holdings and assess return drivers, such as fundamentals and valuations. At the ETF level, we review the ETF’s technicals (supply and demand for the security) and its costs, including transactions costs.
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Why are costs not the top consideration for picking an ETF?
Costs are always a factor in selecting investments. A lower expense ratio and a tighter bid-ask spread provide an edge for any fund. Good investing is about using every edge available, and lower costs are a dependable edge. However, it’s more important to drill down to the underlying holdings and understand the overall risk and return drivers of the ETF.
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What’s the role of factor-based ETFs in your portfolio?
While some investment managers might use smart beta ETFs as satellite positions to their core, we let smart beta do the heavy lifting at CLS. Strategically (long-term), we want to maintain a net aggregate positive tilt toward five equity factors: value, momentum, quality, low volatility, and small-caps. Tactically (short-term), we move our factor exposures based on overall value.
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How do you talk about smart beta ETFs with investors?
Investors need to have a level of comfort with their investments. Our approach is to first explain the basic definitions to make sure we’re all speaking the same language. Next, we talk about the primary virtues of smart beta (lower costs, transparent, and rules-based, which means disciplined and dependable). Finally, we explain smart beta’s historical performance, including its consistency and proven performance in down markets.
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Do you prefer to hold a steady weight to single factors, or do you prefer to time factors?
We want to maintain a net aggregate positive tilt toward the five equity factors at all times, but over the shorter term, we move our factor exposures based on where we see overall value. Sometimes, we might even be underweight a factor if we feel expected returns are not attractive. Factor returns are cyclical.
Thank You
As always, a sincere thank you for reading. If you have any questions or feedback, please let me know.
Stay balanced.
Rusty Vanneman is the Chief Investment Officer at CLS Investments, a participant in the ETF Strategist Channel. He can be reached at [email protected].
This information is prepared for general information only. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. 3276-CLS-12/6/2017