On the recent webcast (available on demand for CE Credit), Strategic Beta’s Due Diligence Dilemma, Jordan Stewart, Manager Research at J.P. Morgan Asset Management, pointed out that while smart beta or strategic beta ETFs try to enhance returns and diminish downside risks, the various strategies’ performances vary more widely than traditional cap-weighted investments, with the margin of difference frequently being the difference between a gain and loss.
Since smart beta ETFs rely on a benchmark index, investors are better able to monitor the strategies and better understand how the funds work. Smart beta ETF’s performance results and portfolio characteristics are based on index construction rules and factor criteria and ongoing monitoring as the process is largely systematized in its rules-based process.
Furthermore, Joe Staines, Research Analyst and Portfolio Manager of J.P. Morgan Asset Management, argued that there is more to smart beta than just screening for specific factors like volatility, momentum, size and value, among others, pointing to a disciplined portfolio construction approach to diversify risk as well. Specifically, J.P. Morgan diversifies risk across regions and sectors through a proprietary risk-weighting process in an attempt to adjust sector, region and stock weights to distribute risk more evenly.
When considering what goes into a smart beta process, Stewart explained that there are four major steps to performing smart beta due diligence, including a starting point, hypotehtical result, investible product and ongoing benchmark tracking.
“Strategic beta due diligence must encompass both the suitability of the index and a manager’s ability to implement it,” Stewart said.
Specifically, we begin at a starting point of a smart beta universe to have a general weighting, geography and sector allocations. The process then implements indexing rules of security selection, portfolio construction and rebalance to achieve a hypothetical resulting smart beta index. The next step involves fund management to include the overall investment process and efficiency of implementing the strategy. We then get the end investible product or smart beta ETF that is able to hit the market. Afterwards, the fund will be monitored for tracking errors to its underlying index over time to bring the ETF back in line with its benchmark.
Larry Whistler, President and Chief Investment Officer of Nottingham Advisors, also explained how investor habits have evolved over time as single factor and multi factor smart beta strategies are growing in popularity. We are witnessing greater demand for multi-factor strategies and ETFs as a way to smooth out the ride and diminish the potential pitfalls of focusing too much on a single smart beta factor. For instance, Whistler mentioned how single factors like minimum volatility may exhibit a higher degree of tracking error, whereas a multi factor combination would reduce the divergence from tracking errors.
The end result is something like the JPMorgan Diversified Return International Equity ETF (NYSEArca: JPIN). The underlying index diversifies risks that are less likely to be rewarded while overweighting areas that are more likely to produce positive results. Staines pointed out that JPIN’s performance from index inception to index launch has exhibited improved risk-adjusted returns relative to traditional market cap-weighted benchmarks like the MSCI EAFE Index.
“Since inception, JPIN has performed as designed, keeping pace with the cap-weighted index on the upside but has captured less of the downside,” Staines said.
Financial advisors who are interested in learning more about smart beta strategies can watch the webcast here on demand.