Smart-Beta ETFs Not All Factors Are Created Equal

More exchange traded fund investors are looking to smart beta or alternative index-based strategies to fill out their investments, and focusing on which targeted factors within the indexing methodology matters when appropriately balancing a portfolio.

On a recent webcast, Smart Beta Factors: How Many and What is Ideal?, Joel Schneider, Senior Portfolio Manager and Vice President of Dimensional Fund Advisors, explained that investors should focus on four factors backed by academic research that have historically driven expected returns, including market equity premium, small-cap premium, value premium and profitability premium.

Related: ETFs Are a Hit Among Financial Advisors

“Academic research has shown that stocks characterized by smaller capitalizations, lower valuations, and higher profitability have delivered higher expected returns over time,” Schneider said.

Specifically, Schneider pointed out that a study conducted by University of Chicago Professor Eugene Fama and Dartmouth College Professor Kenneth French found that focusing on smaller stocks and those with lower relative prices may improve a portfolio’s expected return. Additionally, in a separate research, University of Rochester Professor Robert Novy-Marx identified profitability as another factor that enhances expected returns.

In a survey of advisors participating the webcast, 36% of respondents feel stocks will continue to exhibit a premium over bonds, 31% favor relative price or value over growth style, 27% target profitability and only 6% see a small-cap premium.

While there are many various active styles and factor-based strategies available, these four factors have been persistent across time periods, are pervasive across markets, show long historical data points and can be implemented in a cost-effective manner.

“Not all factor-based strategies are created equal,” Schneider said.