Instead of tracking the markets with broad market-capitalization-weighted investments, investors can potentially enhance returns through new smart-beta exchange traded fund strategies.
On the recent webcast, Rethinking Alpha: New Avenues to Portfolio Enhancement, Mitch Zacks, Director of Quantitative Modeling for Zacks Investment Research, argues that investors can generate alpha through passive index-based ETFs that track actively managed investment styles.
For example, Zacks and ETF Securities have partnered to provide the ETFS Zacks Earnings Large-Cap U.S. Index Fund (NYSEArca: ZLRG) and the ETFS Zacks Earnings Small-Cap U.S. Index Fund (NYSEArca: ZSML), two alpha focused generating ETF methodologies. [ETF Spotlight: Equal-Weight, Small-Cap Earnings Strategy]
Specifically, the two ETFs focus try to generate potential alpha through focusing on earnings.
“The trend in earnings estimate revisions offers investors a potential solution for capturing future alpha in stock market returns,” Zacks said. “Zacks Investment Research is a pioneer in company earnings dissemination, focusing on selecting stocks with the best future earnings potential.”
However, Zacks points out that earnings estimates can only do so much. Consequently, through Zacks Research, the company selection will go through earnings estimates revisions to determine the strength of the buy signals, which tends to have a more objective view than many traditional broker recommendations.
Specifically, Zacks outlines four factors that stock picks are rated on: The extent at which all analysts are revising earnings estimates; the size by which the consensus has changed; the difference between the most accurate estimate and consensus estimate; lastly, the few quarters of EPS surprise. The research team only picks sticks with the strongest buy convictions.
Moreover, the ETFs’ components are selected based on Zacks Quality, which refers to the amount of non-cash components, or accruals, in each company’s reported earnings – only 10% of firms with the lowest sector-adjusted accruals are eligible for inclusion.
“Research shows an inverse relationship between accruals and stock returns – the lower the non-cash component of earnings, the higher the performance tends to be,” Mitch added.
After accounting for the earnings estimates and quality, the component picks are controlled for risk exposure by diversifying across sectors.
Mike McGlone, Head of US Research for ETF Securities, points out that ZSML and ZLRG’s underlying indices first select stocks with high Zanks earnings ranks and then equally weight sectors and stocks to better manage risk – the indices break down the market into 16 sectors, which are initially weighted at 6.25%. [Multi-Layered, Smart-Beta ETFs Break from Traditional Market-Cap Mold]
“An additional level of risk management is achieved by strict liquidity and capacity screens, equally weighting each sector and equally weighting each stock within each sector,” McGlone added.
Financial advisors who are interested in learning more about the Zacks earnings strategies can listen to the webcast here on demand.