“Individual factors can be cyclical and their returns not entirely correlated,” Channing said. “Combining them may potentially lead to better diversification.”
Additionally, to maximize diversification, there are a number of stock weighting strategies. For instance, Maximum De-concentration refers to equally weighting components. Maximum De-correlation weights components according to contribution to overall portfolio correlation. Efficient Minimum Volatility would weight holdings in order to minimize volatility. Efficient Maximum Sharpe Ratio tries to achieve the maximum possible risk-adjusted portfolio returns. Lastly, Diversified Risk Parity refers to weighting components based on the proportion to the inverse of their volatility, so the least volatile stocks have higher weights.
“Individual factors can be cyclical and their returns not entirely correlated,” Mike Cameron, Head of Institutional Sales at ETF Securities, said. “Combining them may potentially lead to better diversification and limit market timing.”
For those interested in investing in these multi-factor strategies, ETF Securities has partnered with ERI Scientific Beta on the relatively new ETFS Diversified-Factor U.S. Large Cap Index Fund (NYSEArca: SBUS) and ETFS Diversified-Factor Developed Europe Index Fund (NYSEArca: SBEU). Scientific Beta is an index provider specializing in smart beta solutions and is part of the EDHEC Risk Institute, an entity that works closely with institutions to implement academic research and improve their investment and risk management process has also recently came out with smart-beta ETFs of its own.
However, potential investors should be aware that these factors and weighting methodologies do not completely remove the risk of investment losses. Instead, these smart-beta indexing methodologies help diminish swings during periods of heightened volatility and reduce falls in times of extreme selling.
Financial advisors who are interested in learning more about the smart-beta ETF strategy can listen to the webcast here on demand.