Smart beta or factor-based exchange traded funds promise to produce enhanced returns and diminish portfolio risk. It is also just as important to understand how the smart beta strategies produce their end result and identify the main drivers of return.
“To get under the hood of a multifactor fund’s return drivers, and gauge their sensitivities, start by regressing the multifactor excess returns on the single factor excess returns, but be aware of the subtleties around this approach,” Robert Bush, ETF Strategist for Deutsche Asset Management, said in a research note.
Bush argued that investors should start by regressing a fund’s excess returns on a number of single factors to determine the right factors that explain the excess returns and what are the sensitivities that affect the factor.
Smart beta or strategic beta exchange traded funds are based on customized indices that screen for specific factors instead of weighting components based on market capitalization. If one selects a multi-factor smart beta ETF strategy, they may be exposed to numerous factors that could affect the outcome of their investment. Consequently, investors should carefully consider the effects of these factors on their ETF investments.
To provide a clearer picture on the effects of these factors, Bush regressed the daily excess returns of the FTSE Russell Comprehensive Factor Index, the underlying benchmark for the popular Deutsche X-trackers Russell 1000 Comprehensive Factor ETF (NYSEArca: DEUS), for the five single factors that the index incorporates, including value, size, momentum, low volatility and quality.
Through the regression, Bush provided a base line, pointing out that the proportion of variability in excess return is explained by the five factors, or overweighting company stocks based on these five factors do indeed provide what you’d hope for.