Smart-beta, or “fundamental,” index exchange traded funds are attracting more investors as the strategies beat traditional beta-index funds. However, potential investors should be comfortable with greater short-term volatility.
Pavilion strategists Pierre Lapointe, Alex Bellefleur and Frances Donald argue that while smart-beta ETFs can generate higher returns than plain vanilla funds, the smart-beta offerings come with higher risks, reports Brendan Conway for Barron’s.
“Every smart beta strategy we tested resulted in higher returns over 20 years,” the analysts said in the article. “But it also came with higher volatility.”
For example, the PowerShares FTSE RAFI 1000 ETF (NYSEArca: PRF), which selects the largest U.S. equities based on book value, cash flow, sales and dividends, has outperformed 85% of large-cap-value funds over the past five-years, outpaced 83% of the funds over a three-year period and beat 87% of large-cap-value funds year-to-date. [Smart-Beta ETFs Beating Active Mutual Fund Rivals]
Over the past five years, PRF generated an average annualized return of 19.2%, compared to the S&P 500’s 15.6% return. Year-to-date, PRF is up 28.4% while the S&P 500 gained 25.8%.
The Pavilion strategists, though, discovered that low-volatility ETF strategies beat the S&P 500 with reduced risk over the long-term.
Low-volatility ETFs, like the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV) and PowerShares S&P 500 Low Volatility Portfolio (NYSEArca: SPLV), have attracted billions. However, the strategy has trailed the S&P 500 this year as equities rallied. USMV is up 23% year-to-date and SPLV is up 21%. [Don’t Forget This Low Volatility ETF]
For more information on smart-beta indices, visit our indexing category.
Max Chen contributed to this article.