In a volatile market environment, exchange traded fund investors should consider the diversification benefits factors may provide and the types of smart beta strategies they may deploy to potentially enhance returns and limit downside risks in an equity portfolio.

On the recent webcast available on-demand for CE Credit, Beyond Factor Fundamentals – and Why They Matter More than Ever Today, Gabriela D. Santos, Executive Director and Global Market Strategist for J.P. Morgan Asset Management, outlined the traditional time frame of market booms and busts, pointing to an average economic expansion of 47 months and recession of 15 months since 1900. With the equity market extending toward its 10th bull market year, investors may more likely experience greater downside risk than further upside potential.

For instance, an early indicator would come from the Federal Reserve as a tighter monetary policy usually results with a strengthening economy that can handle higher interest rates. Nevertheless, Santos pointed out that there has been a positive relationship between yield movements and stock returns, and when yields are below 5%, rising rates have usually been associated with rising stock prices.

Some investors may be worried about the lofty prices in an extended equity market bull rally, but investors are still short of the dotcom-era highs. The S&P 500 exhibits forward price-to-earnings ratio of 18.1x, which is elevated when compared to its historic 25-year average of 16.1x but remains well below the highs of 24x back before the year 2000.

As the financial markets mature and investors grow more knowledgeable about the investment environment, the ETF landscape is also evolving, Josh Rogers Vice President and Beta Specialist for J.P. Morgan Asset Management, said. Specifically, the specialist singled out the growth of strategic or smart beta ETF strategies that incorporate traditionally active styles in a passive, rules-based indexing methodology to generate potentially improved risk-adjusted returns.

Matthew Krajna, Director of Equity Research and Senior Portfolio Manager for Nottingham Advisors, revealed how Nottingham Advisors’ client portfolios have also evolved with the changing times as they now include cap weighted, single-factor and multi-factor ETF exposures to replace traditional large-cap S&P 500 positions. The same is also prevalent in international exposure as options like minimum volatility, other single-factor and multi-factor strategies are now available.

Rogers argued that factor-based strategies like smart beta ETFs can be used to solve different portfolio needs. For instance, single factors help target exposure to enhance returns or address specific client needs, whereas a multi-factor approach may provide a diversified core equity allocation that leverages the benefits of multiple factors and limit cycle risks associated with individual factors.

For example, Rogers looked at the value factor, which has been backed by decades of academic research. Stocks that appear undervalued on the basis of fundamental valuation measures tend to outperform over time. The value theme banks on the belief that higher fixed costs and greater corporate leverage may increase risk during economic contractions. Consequently, investors tend be too optimistic in pricing growth stocks and may overpay, in particular, towards ends of bull markets or when growth is scarce, leaving an opportunity for value to shine.

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