While market factor screens have been an attractive feature of the new breed of smart beta ETFs, potential investors should still look under the hood to better understand the underlying strategies.
On the recent webcast (available On Demand for CE Credit), Smart Investing is More than Factors, Brandon Rakszawski, Product Manager for VanEck, argued that smart beta or factor-based ETF investments that utilize actively managed investment styles is here to stay as more investors become disillusioned with the underperformance of costly active fund strategies.
Over the past two decades, large blend funds have on average underperformed the S&P 500, and the disparity has only widened in recent years.
On the other hand, smart beta ETFs, which implement traditional actively managed investment styles in a rules-based indexing methodology, have quickly garnered assets, and providers continue to add more smart beta ETF strategies to U.S. markets to meet the growing demand. Over one third of ETPs launched in the U.S. since the start of 2016 are classified as strategic beta or smart beta by Morningstar fund research, and almost half of all assets in those newly launched funds are comprised of strategic beta ETPs.
However, Rakszawski warned that while factors are a powerful tool that could help enhance returns, they are not always consistent. For instance, the value factor outperformed across the globe in 2016, but value was the worst performing factor in 2015 as minimum volatility outperformed.
Consequently, investors may consider a mixed basket of market factors as a way to better smooth out the ride over the long-term. For example, Rakszawski highlighted the long-term benefits of a moat investment strategy that focuses on companies with strong economic moats as a way to capture a sustainable advantage.
For instance, the VanEck Vectors Morningstar Wide Moat ETF (NYSEArca: MOAT), which implements Morningstar’s economic moat rating to identify strong companies with wide economic moats, and VanEck Vectors Morningstar International Moat ETF (NYSEArca: MOTI), which takes a similar moat rating methodology to select overseas component holdings, can help investors achieve improved long-term, risk-adjusted return by focusing on quality companies that help limit downside risk while still participating in potential gains.
The Morningstar Economic Moat Rating methodology assign an economic moat rating to companies, but it also focuses on those that show attractive valuations or are more attractively priced. Rakszawski pointed out that beyond factor effects, stock selection is also an important driver as the underlying indices combine both quality and valuation to help investors potentially generate improved returns.
Dan Lefkovitz, Content Strategist, Indexes at Morningstar, explained that the economic moat methodology focuses on five sources of economic moats: Intangible assets or things like brands, patents and regulatory licenses that block competition or allow a company to charge more. Switching costs or the expenses that a customer would incur to change form one provider to another. Network effect that is present when the value of a service grows as more people use a network. Cost advantage or the ability that allows firms to sell at the same price as competitors and gather excess profit or have the option to undercut competition. Lastly, efficient scale where a company services a market limited in size, so new competitors may not have an incentive to enter.
The economic moats may help predict good things. For instance, Lefkovitz argued that wide economic moats may help identify companies with liquidity and high return on assets, whereas those with narrow economic moats have more financial leverage, greater volatility and greater drawdowns.
Financial advisors who are interested in learning more about factor-based investments can watch the webcast here on demand.