Smart-Beta Sector ETFs to Navigate Current Markets

After a multi-year rally, the equities market is trading at elevated valuations. Consequently, investors seeking exposure to stocks may want to consider a smart-beta, multi-factor exchange traded strategy to limit risks and potentially enhance returns.

“High Valuations and limited multiple expansion may hinder broad market returns,” Steve Deroian, Head of ETF Strategy at John Hancock Investments, said on the recent webcast, A Smart (Beta) Approach to Sector ETFs, predicting minimal price-to-earnings multiple expansion this year.

Nevertheless, Deroian pointed to certain sectors that may offer growth opportunities at a reasonable price. For instance, looking at the PEG ratios of the S&P 500 sectors – the price/earnings-to-growth ratio, the strategist calculated that the financials, healthcare, technology and consumer discretionary sectors appear undervalued, whereas telecommunications, utilities and consumer staples are trading at more pricier valuations. John Hancock has a more neutral view on industrials and materials.

Many would turn to market-cap weighted or actively managed sector strategies to gain targeted exposure to these market segments. However, Deroian warned of the potential shortfalls, such as high concentration in individual securities in market-cap weighted funds or the high turnover and trading costs in active funds.

In a survey of financial advisors on the webcast, 35% of respondents pointed to reducing volatility as their main motivation for smart-beta investments, followed by 31% who want higher returns and 27% who want to diversify away from market capitalization.

Alternatively, investors may look to a smart-beta, factor-based index ETF strategy for broad diversification. For instance, Joel Schneider, Senior Portfolio Manager & Vice President of Dimensional Fund Advisors, pointed to four factors backed by academic research that have historically shown higher expected returns over time, including the equity premium, small-cap premium, value premium and profitability premium.

Specifically, the market equity premium reflects the outperformance of stocks over bonds. The small-cap premium corresponds to the outperformance of small-caps over large-caps. The value premium relates to value stocks over growth stocks. Lastly, the profitability premium shows that highly profitable companies tend to do better than less profitable companies. On the webcast survey, the majority of advisors pointed to relative price or valuations over growth as the most attractive factor in the current environment.