ETF Trends
ETF Trends

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.

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Specifically, the quality factor is based on profitability, efficiency, earnings quality and limited leverage, which have historically been a good way to separate good companies from weaker ones. A volatility screen is also in place to focus on stocks that exhibit lower volatility, which tend to perform better. Additionally, the funds select stocks with strong dividend yields, which have also typically outperformed. The result is a portfolio of quality global companies and brands, O’Brien said.

O’Leary also advised investors to look beyond U.S. markets and include international exposure for a more diversified investment portfolio. International markets may zig as U.S. markets zag, bolstering returns or limiting pullbacks. For example, over 2015, U.S. equities returned 1.4% while European markets rose 10.3% and Japanese stocks gained 12.1%.

Investors can also gain exposure to Asia and Europe through the O’Shares FTSE Europe Quality Dividend ETF (NYSEArca: OEUR) and the O’Shares FTSE Asia Pacific Quality Dividend ETF (NYSEArca: OASI). OEUR tracks the FTSE Europe Qual / Vol / Yield Factor 5% Capped Index. OASI follows the FTSE Asia Pacific Qual / Vol / Yield Factor 5% Capped Index.

Zucker explained that the multi-factor FTSE Russell Indices are constructed by taking a stock’s market cap weighting multiplied by all factor scores – quality, volatility and yield – to generate an unadjusted weight. Those with the highest overall score would then be given a larger allocation within the Index.

Michael Venuto, Co-Founder and Chief Investment Officer of Toroso Investments, also pointed out that funds like OUSA have a clear process for security selection that allows investors to gain exposure to active management styles in a passive index-based ETF wrapper.

So far this year, this alternative, multi-factor indexing methodology has worked out for the smart-beta ETFs. For instance, OUSA’s underlying index’s overweight consumer goods and utilities components have helped the fund outperform the benchmark FTSE USA Index, which is overweight financials and technology segments.

SEE MORE: O’Leary’s O’Shares Seeks Big Additions to its ETF Lineup

Looking ahead, O’Shares will be aggressively expanding its ETF suite with 17 new fund strategies waiting on approval from the Securities and Exchange Commission. The new ETF filings all show a common “Quality” theme, which suggests that the underlying indices will also employ a type of smart-beta indexing methodology to weed out weaker securities.

Financial advisors who are interested in learning more about quality, smart-beta strategies can watch the webcast here on-demand.