Factor-Based, Smart Beta ETFs to Help Strengthen Core Portfolio

Investors should consider factor-based ETFs that can potentially address the risks posed by traditional cap weighting and enhance the core of their portfolio with multi-factor strategies.

On the recent webcast, Strengthening Your Portfolio’s Core with Multifactor ETFs, Ryan Wellman, Product Manager, John Hancock Investments, argued that investors should look to passive investments as a way to better build their core allocation, given index-based strategies’ lower fees, transparency and low tracking error.

Actively managed funds have historically shown performance when compared to passive assets. For example, under 50% of actively managed mid-cap blend, large-cap blend, foreign large-cap blend, small-cap blend and foreign small/mid-blend fund categories have all underperformed their benchmarks. In the 20-year period that ended 2018, 23% of actively managed funds have outperformed their benchmarks and only 42% of active funds have survived or not closed down over the period.

However, this does not mean that actively managed styles do not have their own merits. Wellman pointed out that passive index-based strategies do not offer the opportunity for outperformance since they passively track a benchmark. Furthermore, there are no risk controls, or these index-based investments don’t account for valuation concentration or single stock risk.

Consequently, Wellman argued that investors could be better served with a lower fee, rules-based approach that provides market exposure yet drives outperformance through improved index design, such as a factor-based or smart beta ETF strategy.

To help investors better access these factor strategies to enhance returns and diminish downside risks, John Hancock Investments has partnered with Dimensional Fund Advisors to launch a number of factor-based ETF strategies. Andres Torres, Portfolio Manager, Dimensional Fund Advisors, outlined four major factors that help drive expected returns for their smart beta strategies, 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.

Torres also highlighted a study conducted by University of Chicago Professor Eugene Fama and Dartmouth College Professor Kenneth French that found focusing on smaller stocks and those with lower relative prices may improve a portfolio’s expected return. Additionally, in a separate research paper, profitability is seen as another factor that enhances expected returns over time.

When combined, the various factors may help improve a portfolio’s risk-adjusted returns over time. Torres explained that the Dimensional Fund Advisors’ multi-factor strategies select securities of a specific sector with a desired market capitalization range, with an increase emphasis on higher expected return securities. The securities will exhibit lower relative price, higher profitability and lower market capitalization. Moreover, securities’ weights are capped to diminish concentration.

“Current market prices contain information about expected returns, but it takes expertise to extract and apply that information throughout the investment process,” Torres said. “For over three decades, Dimensional has invested using a systematic approach that focuses on all aspects of implementation, from deciding what premiums to pursue to intelligent portfolio structure to efficient portfolio management and trading.”

John Hancock has come out with a number of smart beta ETF options that track indices developed by Dimensional Fund Advisors, including the John Hancock Multifactor Large Cap ETF (NYSEArca: JHML), John Hancock Multifactor Mid Cap ETF (NYSEArca: JHMM) and John Hancock Multifactor Small Cap ETF (NYSEArca: JHSC), along with a suite of multi-factor sector-specific ETF strategies, to help investors to overweight targeted areas of the market.

The sector-specific, smart beta ETFs include the John Hancock Multifactor Consumer Discretionary ETF (NYSEArca: JHMC), John Hancock Multifactor Financials ETF (NYSEArca: JHMF), John Hancock Multifactor Healthcare ETF (NYSEArca: JHMH), John Hancock Multifactor Technology ETF (NYSEArca: JHMT), John Hancock Multifactor Consumer Staples ETF (NYSEArca: JHMS), John Hancock Multifactor Energy ETF (NYSEArca: JHME), John Hancock Multifactor Industrials ETF (NYSEArca: JHMI), John Hancock Multifactor Materials ETF (NYSEArca: JHMA) and John Hancock Multifactor Utilities ETF (NYSEArca: JHMU).

Financial advisors who are interested in learning more about multi-factor strategies can watch the webcast here on demand.