Seasoned fund industry player Legg Mason Inc. (NYSE: LM) has launched four smart-beta or alternative index-based exchange traded funds that bring institutional styled strategies to retail investors.
The new Legg Mason ETFs highlight the importance of risk management, especially during the current environment of heightened volatility.
For instance on Monday, the huge 7% sell-off in China has dragged on the emerging markets space – Chinese stocks make up about 25% of the MSCI Emerging Markets Index. However, investors could have diminished their exposure to this more volatile segment of the developing world through a smart-beta ETF, such as the recently launched Legg Mason Emerging Markets Diversified Core ETF (NasdaqGM: EDBI), which includes about a 10% tilt toward China.
Along with EDBI, Legg Mason has come out with the Legg Mason Developed Ex-US Diversified Core ETF (NasdaqGM: DDBI), Legg Mason US Diversified Core ETF (NasdaqGM: UDBI) and Legg Mason Low Volatility High Dividend ETF (NasdaqGM: LVHD).
A Macro, Top-Down Approach
Through a partnership with QS Investors, three of the new funds take a macro, top-down approach that help balance risk to deliver broad market exposure. QS Investors has provided custom solutions for institutional and pension funds for 15 years. Specifically, EDBI, DDBI, UDBI all follow QS Investors’ proprietary Diversification Based Investing (DBI) rules-based methodology.
“We broke the strategy down into a rules-based methodology so we can run it in an index,” Rick Genoni, Head of the ETF business at Legg Mason, told ETF Trends in a call.
The new funds break down the universe of securities into investment categories based on sectors and countries. The five-year return patterns of the countries and sectors are taken to uncover relationships – areas that behave alike or differently.The index then combines investment categories with more highly correlated historical performance into smaller number of so-called clusters, which are categorized based on tendency to behave similarly, or show various correlations. Each of these clusters are then equally weighted individually and also equally weighted across the portfolio to produce a diversified investment strategy.
“Our research has shown that sector and country allocations in an equity portfolio are the main drivers of portfolio performance,” according to Legg Mason. “Those who want to invest across equity markets may want to focus on diversification and limit exposure to countries and sectors that behave similarly.”
Diminishing Concentration Risk
Consequently, through the DBI approach, the group of global stock ETFs should exhibit low correlation of excess return to active stock managers and traditional market cap-weighted indices. Genoni explained that the DBI methodology helps diminish concentration risk within country and sector exposures. For instance, the U.S. index may better manage biotechnology exposure, which Genoni likens to 90s dotcom era. “Most investors don’t realize that biotech now represents approximately 30% of the weight in the healthcare sector but actually behaves more in line with Internet companies and venture capital than it does with traditional health care companies”, Genoni added.”
Additionally, Legg Mason came out with a low-vol, high dividend strategy, which should help investors who are seeking new sources of yield in a changing market environment. Currently, fixed-income investors would increase exposure to credit risk to generate greater yields, or investors could look to riskier dividend-paying stocks like master limited partnerships.
Alternatively, “coupling low-vol with high yield screens makes a lot of sense as these factors complement each other,” Genoni added.
Specifically, LVHD focuses on U.S. equity stocks with relatively high yield and low price and earnings volatility, and the fund also targets profitable companies. The ideas is that a stock’s ability to sustain strong dividends is associated with lower volatility.
“Research has observed a ‘low-volatility anomaly,’ where stocks with lower volatility than the overall market have historically outperformed on risk-adjusted basis over time,” according to Legg Mason.
Legg Mason also argues that these new smart-beta ETFs may be best utilized alongside traditional market cap-weighted index funds to potentially mitigate concentration risk, or help investors generate improved risk-adjusted returns.
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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.