In the rapidly expanding exchange traded fund industry, alternative or smart-beta ETFs have experienced a rapid ascent as investors capitalize on actively managed styles in a passive index-based fund wrapper.
There are about 400 smart-beta U.S.-listed funds on the market, with $400 billion in assets under management, or about 20% of total U.S.-listed ETFs, report Anthony Effinger and Eric Balchunas for Bloomberg.
Arguably, it all started when the first non-traditional market-cap-weighted ETF hit the market and quickly evolved into customized indices that implement factors in selecting stock components.
For instance, the PowerShares FTSE RAFI US 1000 Portfolio (NYSEArca: PRF), which tracks a Research Affiliates index, selects stocks based on book value, cash flow, sales and dividends. It is also one of the longest running smart beta ETFs on the market and will hit its 10th anniversary in December.
The strategic beta, scientific beta, factor-based investing or fundamental indexing ETFs are all based on a rules-based index that implement a highly regimented investment objective and mirrors actively managed styles.
Rob Arnott, chairman and co-founder of Research Affiliates, believes smart-beta helps sever the link between price of a stock and its weight in an index. Some argue that the alternative indexing style helps address some of the short-comings of market-cap index funds, which overweight outperforming stocks. [Arnott, Draper Talk Fundamental Indexing]
“By linking the weight to price, the more expensive something is, the bigger your holding,’’ Arnott said in the article, pointing out that cap-weighted fund investment means buying stocks because other people like them not because they’re better companies. “Why on earth would you want to do that?’’
Since the smart-beta methodology is all automated through an index, Tom Dorsey of Dorsey, Wright & Associaites argues that he acts more like a robot designer. If his team were to suddenly disappear, the algorithms that direct DWA index-based, smart-beta ETFs would keep on running. [Nasdaq Boosts Index Business With Dorsey Wright Acquisition]
“Once a quarter, we press a button,’’ Dorsey said in the article, pointing out that the algorithms generate a list of investments for something like the First Trust Dorsey Wright Focus 5 ETF (NasdaqGM: FV). “We just need someone to press the button.’’
Dorsey, Wright & Associates has also been long-time partner with the PowerShares suite of momentum ETFs. For example, the Powershares DWA Momentum Portfolio (NYSEArca: PDP) picks out stocks based on relative strength.
“Relative strength improves upon the technical foundation of basic trend following because it relies on unbiased, unemotional and objective data, rather than biased forecasting or subjective research,” according to PowerShares.
So far, some of these alternative index-based strategies have helped generate greater performance. For instance, PRF has outpaced the S&P 500 index since it started on Dec. 19, 2005, returning 120% compared to the 103% from the S&P 500. Since it began trading in March 2007, PDP has returned 82%, whereas the S&P 500 gained 78%.
For more information on alternative index funds, visit our smart beta category.
Max Chen contributed to this article.