How a Rules-Based, Smart-Beta ETF Can Enhance a Portfolio

Market capitalization-weighted strategies dominate the fund industry. Alternatively, a new breed of smart-beta exchange traded funds that adhere to strict rules-based indices could help enhance an investment portfolio.

On the recent webcast, Kevin O’Leary (Shark Tank); Performance of ETFs Focused on Quality Stocks, Kevin O’Leary, Chairman of O’Shares Investments, said that rules-based or custom index-based ETFs are one of the fastest growing segments of the fund industry.

Supporting the rising popularity of these rules-based strategies, smart-beta ETFs leverage academic research to capture a market upside while limiting downside risks to potentially generate improved risk-adjusted returns, or what O’Leary dubs “winning by losing less.”

For instance, the O’Shares FTSE US Quality Dividend ETF (NYSEArca: OUSA), which tracks the FTSE US Qual / Vol / Yield Factor 5% Capped Index, captured 93% of the upside compared to the S&P 500 for the year ended July 31 but only experienced -47% of downside compared to the market benchmark.

“Historically, the factor index has captured more of the markets’ upside than downside,” Brad Zucker, Senior Product Manager at FTSE Russell, said.

In a survey of financial advisors attending the webcast, 65% of respondents believe that factor based index strategies can provide better performance with less volatility than traditional cap-weighted indices. However, 33% said they require more research, which suggests that the industry still needs to further educate investors before more will adopt these smart-beta ETFs.

O’Leary pointed to company dividends as a source of historic returns as a supporting factor for long-term performance – dividends accounted for 70% of total return over the past 40 years.

Connor O’Brien, Chief Executive Officer and President of O’Shares Investments, explained that the O’Shares ETFs follow a rules based approach built on FTSE Russell Disciplined Rules.