The 5 Cs of Evaluating Smart Beta ETFs | ETF Trends

With U.S.-China trade deal negotiations going into a state of uncertainty, investors are seeing volatility return to the capital markets. The latest market movements emphasize the need for smart beta strategies–an extension of the overarching theme for investors to get strategic in 2019.

But what exactly is smart beta?

“Smart beta, also called factor investing, is rooted in academic research from Eugene Fama, a professor at the University of Chicago’s Booth School of Business, and Ken French, a finance professor at the Tuck School of Business at Dartmouth College,” wrote Debbie Carlson in U.S. News. “They found certain investment factors such as a company’s size, a firm’s price-to-book ratio and market risk would over time outperform the broader S&P 500 index.”

With the gist of smart beta in mind, investors must now understand exactly how they help during times of market volatility. This is essential given that investors nowadays prefer to have this downside protection built in to ETF products.

“It’s like a hedge strategy,” said Kip Meadows, founder and CEO of Nottingham, a fund administration firm and white-label ETF issuer in Rocky Mount, North Carolina. “If you have a downturn, the theory is the company that has the better fundamentals, like a higher dividend, it should outperform and provide investors protection.”

For a further understanding of smart beta, here are five concepts according to Lance Humphrey, Portfolio Manager at USAA Asset Management Company:

  1. Combination: how factors combine
  2. Concentration: how many stocks to choose
  3. Construction: how stocks are weighted
  4. Constraints: headwinds for the selections
  5. Craftsmanship: how is the ETF built

“Coming from the space where we evaluate active managers, people typically fall back on what they call the four Ps–people, process, philosophy, performance,” said Humphrey. “When looking at smart beta ETFs, we really need to develop a new framework on how we think about those types of things so what we look at is what we call the 5 Cs.”

However, smart beta investors don’t have to assume more risk in order to ferret out the most profitable opportunities. Smart beta strategies can help limit the downside in market drawdowns and capture gains when markets are in an upswing.

“For investing purposes, we make the assumption that the more risk we take, the more return we receive is true across everything that we do in investing,” said Alex Piré, Head of Client Portfolio Management, Natixis Seeyond. “Our studies and academic research have shown that’s not the case. If you’re allocating across risky assets, it’s not the same thing as if you’re allocating across stocks that potentially have very high correlations to each other.”

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