The ascent of smart beta or intelligent index exchange traded funds is undeniable.
“One-quarter of exchange-traded fund (ETF) inflows in the first 11 months of 2013—$41 billion—went into ETFs characterized as smart beta by Morningstar. Total assets in smart beta ETFs as of that point in time stood at $271 billion, approximately 17% of the total assets in ETFs,” according to WisdomTree research. [Evaluating Smart Beta]
Some market observers view the rise of intelligent indexing and the strategy’s increasing use in the ETF world as a threat to market capitalization-weighted funds. However, battle lines need not be drawn, nor do advisors and investors need to pick one type of indexing strategy while ignoring the other. In fact some, ETF strategists are already marrying cap-weighting and smart beta in client portfolios. The Astor Long/Short Balanced Strategy is a prime example.
“The Astor Long/Short Balanced Strategy starts with macroeconomic analysis, including fundamental indicators, such as employment and output, to gauge the current phase of the economic cycle,” said S&P Capital IQ in a research note. “From here, tactical asset allocation across a broad range of asset classes is employed using ETFs to create potentially higher risk-adjusted returns. In times of expected economic expansion, the strategy favors U.S and international equities. But during periods of contraction, Astor increases the fixed income and cash allocations and will incorporate inverse equity ETFs that benefit when equities decline in value. The latter is used to reduce downside volatility, which was helpful in protecting wealth during 2008. However, as of February 2014, Astor was not using inverse products in this strategy.”
Proving that smart beta and cap weighting can coexist in the same strategy, the two largest holdings in the Astor Long/Short strategy at the end of last year were the iShares Core S&P 500 ETF (NYSEArca: IVV) and the Guggenheim S&P Equal Weight ETF (NYSEArca: RSP), both of which are rated overweight by S&P Capital IQ. As an equal weight spin on the S&P 500, RSP reduces exposure to the mega-cap names that are so prominent in the benchmark U.S. index. [Equal Weight ETFs for Everyone]
“RSP has distinct sector weightings including currently higher Consumer Discretionary and lower Information Technology exposure. In 2012 and 2013, RSP outperformed IVV, though it incurs greater volatility and contributes to S&P Capital IQ’s neutral risk considerations,” according to S&P Capital IQ.
Smart beta also includes low volatility ETFs, which are among the most popular intelligent index products on the market today. Astor’s strategy also includes the iShares MSCI USA Minimum Volatility ETF (NYSEArca: USMV), the second-largest low volatility ETF and the iShares High Dividend ETF (NYSEArca: HDV), both of which are also rated overweight by S&P Capital IQ. HDV allocates a combined 46% of its weight to consumer health care stocks and has a trailing 12-month yield of 3.2%. [Another Look at Volatility ETFs]
ETF strategists are also using smart beta ETFs to make sector bets. Well-known smart beta sector ETFs include the First Trust Technology AlphaDEX Fund (NYSEArca: FXL). The $852.2 million FXL, like the other AlphaDEX ETFs, combines growth and value factors rather than relying on market value.
With a median market value of $8.46 billion, it is clear that FXL is not overly dependent on small-caps to generate returns, a frequent critique of smart beta strategies. Rated marketweight by S&P Capital IQ, FXL is up almost 36% in the past year.
Guggenheim S&P Equal Weight ETF
Tom Lydon’s clients own shares of RSP.