Diversified-Factor, Smart-Beta Approach to Enhance ETF Returns

As investors try to diversify an investment portfolio, many have turned to smart-beta exchange traded funds that track alternative indices to potentially generate enhanced returns.

“Many investors are moving away from traditional market-cap indices to smart beta in search of better returns and lower costs,” Alexander Channing, Director of Quantitative Cross Asset Index Strategies at ETF Securities, said on the recent webcast, The Evolution of Smart Beta 2.0.

U.S.-listed ETFs have gathered over $2 trillion in assets under management and smart-beta funds now make up about 20.1% of the U.S. ETF assets.

Channing argues that the shift away from market-cap indices to smart beta may be due to the potential shortcomings in traditional beta indices. Specifically, cap-weighted indices are not designed to maximize risk-adjusted performance, tilt toward unrewarded factors and have low level of diversification. Market cap-weighted indexing methodologies would overweight the biggest stocks that have gathered the most investment dollars, potentially exposing investors to overbought segments of the market.

As a solution to the market-cap weighting methodology, smart beta 1.0 indices came out and focused on one issue at a time. These single factor tilts include value or growth. Additionally, some like the equal-weight methodology, tried to improve diversification.

Now, there are number of more sophisticated products in what Channing calls smart-beta “2.0” indices, which aim to provide a comprehensive approach by addressing both factors and multi-weighting strategies in one index.

When identifying the appropriate factors, Channing pointed to the four common investment characteristics including low volatility, small size, momentum and value. These four factors make up a “multi-factor” approach to potentially lead to better risk-adjusted returns.