Smart Beta ETFs for a Stronger Core | ETF Trends

Exchange traded fund factor-based strategies can provide exposure to the long-term drivers of returns.

In the recent webcast, How to Strengthen Your Core with ETFs, John Feyerer, Sr. Director of Equity ETF Product Strategy, Invesco, and Nicholas Kalivas, Senior Equity Strategist, Invesco, argued that factor-based strategies could help enhance an investor’s core investment portfolio.

“As you look at the holdings within your core portfolio, you might notice that Bulk Beta, although inexpensive, follows the market, and you can’t beat the market if you own the market. Traditional alpha is higher in cost and requires skill, expertise, or some advantage to potentially outperform. Investors are looking for solutions that help them target their goals within their core holdings, while not mimicking the benchmark. This has created an opportunity to strengthen your core,” the strategists said.

Specifically, the strategists highlighted market style factors that can help mitigate risk and drive long-term returns. For example, value applies to investments trading at discounts to similar securities, based on measures like book value, earnings, or cash flow. Size represents the potential higher-than benchmark returns associated with relatively smaller stocks within the universe being considered. Low Volatility describes investments that consistently demonstrated lower volatility than securities in the same asset class. Momentum identifies investments with positive momentum or negative momentum to calibrate portfolio exposure to either. Quality characterizes companies with strong measures of financial health, including a strong balance sheet and earnings growth. Lastly, Dividend Yield reflects investments defined by higher-yielding assets with higher total returns over time than lower-yielding assets.

“Factors provide investors with a multi-dimensional approach and allow for more precise targeting of specific drivers of risk and return,” the strategists said.

Through an ETF investment vehicle as part of a core investment portfolio, investors can gain targeted exposure to these traditional actively managed factor investment strategies in a passive, tax-advantaged, fully transparent, rules-based indexing methodology backed by high liquidity, tradability, and accessibility at a low cost.

Factor investments may also help investors better capitalize on prevailing market trends during various economic or market cycles. For example, in the current recovery phase of the economic cycle, the Size and Value factors tend to outperform. In the expansion phase, the Size, Value, and Momentum factors stick out. In the slowdown phase, the Low-Volatility and Quality factors stand out. Lastly, in the contraction phase, investors should focus on the Momentum, Low-Volatility, and Quality factors.

To help investors target these various market factors, Invesco has come out with a suite of factor-based ETF strategies. For example, the Invesco S&P 500 Quality ETF (NYSEArca: SPHQ) is a popular ETF in the quality category. Quality companies have strong balance sheets and stable earnings growth. Quality stocks have historically outperformed lower-quality shares during periods of escalating market volatility. Additionally, the factor focuses on the overlooked balance sheet metrics that can be important drivers of stock returns.

According to Invesco, quality stocks have captured 97.39% of the up capture, while mitigating risk on the down capture. This has translated to an Alpha of 3.87% and better risk-adjusted returns, as shown a 0.78 Sharpe Ratio.

“The quality screen employed by the index may enhance risk-adjusted returns by selecting profitable companies with strong balance sheets and earnings quality, as measured by a low accruals ratio,” the strategists said.

Investors can target the size factor through something like the Invesco S&P 500 Equal Weight ETF (RSP). RSP equally weights it, so it leans toward smaller companies or reduced concentration risk to the largest companies compared to the cap-weighted benchmark S&P 500 Index. The Size factor offers the potential higher-than-benchmark returns associated with relatively smaller stocks within the universe being considered. Smaller capitalization companies tend to have higher growth potential, and they are less liquid and less widely researched, so investors should earn a premium for investing in them.

Additionally, the Invesco S&P 500 Low Volatility ETF (SPLV) can provide a way for investors to focus on company stocks that exhibit a low volatility metric. The strategy offers the purest approach to harvesting the low volatility anomaly. It has the potential to mitigate downside risks and participate in rising markets. The unconstrained methodology that reconstitutes quarterly results in dynamic sector allocation as well. According to Invesco, investors experienced greater participation in rising markets relative to the drawdown experienced in falling markets, with a 69% average upside capture ratio and a 54% average downside capture ratio.

Financial advisors who are interested in learning more about core investment strategies can watch the webcast here on demand.