Investors interested in smart beta exchange traded fund strategies should consider the factor implications when constructing portfolios and better understand the drivers of risk and return within their portfolio.
On the recent webcast, Beyond Factor Fundamentals – Diagnose Your Factor Exposure, Joe Staines, Research Analyst and Portfolio Manager at J.P. Morgan Asset Management, broke down the taxonomy of factor investments. We would look at economic factors as a descriptor of risk where compensated factors cover those witha positive economic return or referred to as risk premia and uncompensated factors with no economic source of persistent returns.
These compensated factors include market risk premia like equity beta, credit and duration. Additionally, investors may also be coming to know alternative risk premia like value, trend, merger arbitrage, carry and quality.
On the other hand, uncompensated factors include broad market categories like region or sectors that don’t inherently provide persistent real returns, or macro factors like inflation and energy prices.
Joe Smith, Senior Market Strategist for CLS Investments, pointed to seven widely viewed factors that smart beta investors may be familiar with, including size, value, momentum, minimum volatility, quality, duration and credit.
“An important subset of smart beta is factors, which are broad, persistent
drivers of risk and return,” Smith said.
Smart Beta seeks to incorporate the best attributes of passive and active investing to create a more innovative way to manage money, Smith explained. Specifically, smart beta covers rules-based or active screening and weighting methodologies in an unmanaged or passive index-based solution. The result is a portfolio that helps manage beta while seeking to preserve alpha or enhance returns while diminishing downside risk.
However, when considering market factors, investors should also be aware that these factors may act differently in varying conditions, often riding market cycles troughs and peaks. Consequently, some may consider combining the various factors into a more diversified approach.
“Relying on one factor is fine if you have a very high conviction view, but almost all investors will be better served by a diversified portfolio of factors,” Staines said.
For example, J.P. Morgan has come out with a line of U.S. smart beta ETFs, including broad strategies like the JPMorgan Diversified Return US Equity ETF (NYSEArca: JPUS) that covers single-factor strategies. However, investors who have conviction in a given market factor may focus on targeted exposure with options like the J.P. Morgan U.S. Value Factor ETF (NYSEArca: JVAL), J.P. Morgan U.S. Quality Factor ETF (NYSEArca: JQUA), J.P. Morgan U.S. Momentum Factor ETF (NYSEArca: JMOM), J.P. Morgan U.S. Minimum Volatility ETF (NYSEArca: JMIN) and J.P. Morgan U.S. Dividend ETF (NYSEArca: JDIV).
“Instead of playing with sector allocations, decide to overlay portfolio with factor ETFs,” Smith said, explaining that investors can use factor-based ETFs “with goal of reducing portfolio risk while preserving embedded alpha.”
Financial advisors who are interested in learning more about smart beta factor-based investments can watch the webcast here on demand.