Why Smart Beta ETFs Will Likely Gain More Traction in 2018

By Todd Rosenbluth, CFRA

While much of the new money pouring into equity ETFs in 2017 has been to the broad, market-cap weighted U.S. and international products, smart-beta ETFs will likely gain in popularity in 2018. CFRA expects a lower total return for the S&P 500 index in 2018 than what is likely to be achieved in 2017 and, as such, investors will either look for some downside protection or potentially stronger-than-benchmark returns. Yet, investors must understand that what’s inside these alternatively weighted ETFs is not as static as with other offerings.

Two of the ten largest inflows in November occurred in iShares smart-beta ETFs. iShares Edge MSCI USA Minimum Volatility ETF (USMV) and iShares Edge MSCI USA Momentum (MTUM), pulled in $1.3 billion and $1.2 billion, respectively, last month. This was behind iShares Core S&P 500 (IVV) and Vanguard S&P 500 ETF (VOO), but ahead of iShares Core MSCI EAFE (IEFA). While these latter three index ETFs continue to own many of the same stocks in similar weightings as earlier in the year, USMV and MTUM are constructed differently following an end-of-November rebalance, as is PowerShares S&P 500 Low Volatility (SPLV), a USMV peer.

CFRA provides a forward-looking rating on approximately 1,100 equity ETFs using a combination of holdings-analysis and fund attributes. These include a review of the valuation and risk of the constituents as well as the ETF’s expense ratio and technical trends. While this is useful for market-cap weighted ETFs, as the fundamental and technical assessments can change as the market moves, periodically reconstituted smart-beta ETFs require further due diligence.

From a top-down perspective, USMV does not look that different currently than in late November prior to the semi-annual reconstitution and rebalance process. Unlike some other smart-beta offerings, USMV has some constraints and as such it can only over-or underweight sectors relative to a non-smart-beta MSCI USA index by 500 basis points.  Meanwhile, exposure to health care shrunk by 280 basis points. The reduced overweighting stemmed in part from the elimination of Hologic (HOLX) and Patterson (PDCO) and trimming of Abbott Laboratories (ABT) and Becton Dickinson (BDX). As of December 7, health care was USMV’s second largest sector (17% of assets). The largest sector remained information technology (an unchanged and underweighted 20% of assets), with prior positions Accenture (ACN), Facebook (FB) and Visa (V) now joined by new addition Harris Corp (HRS); Adobe Systems (ADBE) was removed in November.