Smart-beta or alternative index-based exchange traded funds may help investors avoid risks associated with traditional beta indexing or a market capitalization-weighted methodology.
On the recent webcast, What is Smart Beta? Understanding the Next Generation of ETFs, Linda Zhang, Senior Portfolio Manager and Head of Research at Windhaven Investment Management, pointed out some limitations in market cap-weighted equity indices that may expose investors to unwanted risks.
For instance, as a market-cap weighted index, the Nasdaq-100 is top heavy, with a large tilt toward the the largest companies. Apple (NasdaqGS: AAPL) weight in the index is the equivalent to the bottom 50 names, Zhang said. A play on the Nasdaq-100 is essentially a large bet on Apple stock.
The market cap-weighted indices may also expose investors to other fundamental risks as the weighting methodology would attach more weight toward indebted countries or companies, Zhang added. For example, looking at the Bloomberg Eurozone Sovereign Debt Index, four of the top five country tilts are those with above average public debt relative to the size of their respective economies – a market cap-weighted bond index would have larger positions in countries that have issued more bond securities, or those with more debt.
On the other hand, investors may turn to factor-based or smart-beta ETFs to capture alternative indexing methodologies.
“Multi-factor strategy may provide more consistent return premium due to factor diversification,” Zhang said.
Robert Bush, ETF Strategist at Deutsche Asset Management, explained that multiple factors like quality, momentum, size, value and volatility may help compensate investors over time while diminishing a portfolio’s risks.
“Academic research has identified certain stocks characteristics that are important in explaining a stock’s risk and performance,” Lance Allen, ETF Regional Vice President of Deutsche Asset Management, said. “Emphasizing these factors can potentially make a significant contribution to outperforming traditional market-capitalization weighted benchmark indices.”
Bush also pointed out that FTSE Russell Indexes may define the factors in a number of ways. For instance, value is a composite measure of cash-flow yield, earnings yield and sales-to-price. Quality is a measure of a company’s profitability, efficiency, earnings quality and leverage. Momentum shows the 11-month total return, lagged 1 month. Volatility represents the standard deviation of five years of weekly total returns of each company stock. Lastly, size encompasses each company’s full market-capitalization in U.S. dollars.
“Exposure to uncorrelated factors may reduce index volatility and mitigate market directionality,” Brad Zucker, Senior Product Manager at FTSE Russell, said.
Investors interested in ETFs that implement these multi-factor indexing methodologies can take a look at the relatively new Deutsche X-trackers Russell 1000 Enhanced Beta ETF (NYSEArca: DEUS) and Deutsche X-trackers FTSE Developed ex US Enhanced Beta ETF (NYSEArca: DEEF), which both track enhanced beta FTSE Russell indices that target quality, momentum, value, size and volatility – five key factors many financial institutions have looked at to help gain an edge over traditional beta indexing methodologies.
Financial advisors who are interested in learning more about smart-beta or factor-based ETF strategies can listen to the webcast here on demand.