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Are you Smarter Than Your ETF?

Wall Street’s Best Editor’s Note: This article was recently featured in Wall Street’s Best contributor Ron Rowland’s All Star Investor. Here, Ron dissects an ETF strategy that has gained the attention of investors in the past few years.

“Investment methodologies that select and weight portfolio securities by factors other than market capitalization have been around for decades. Personally, I have relied heavily on the momentum factor since the mid-1980s. However, many investors have become aware of these alternative investment approaches only over the past few years. I believe that the recent acceptance of smart-beta ETFs by the financial media has been one of the driving forces behind this change.

“In the early 1990s, Eugene Fama and Kenneth French introduced a three-factor investment model based on company size, price-to-book ratio, and market risk. Although many notable mutual fund and institutional investors had been using multifactor models for years, Fama and French were among the first to publish their underlying research.

“The advent of ETFs has made it easier for product developers to roll out new ideas and repackage existing approaches for general consumption. Equal weighting, dividend weighting, fundamental weighting, and other portfolio-construction techniques have quickly become available in a convenient ETF wrapper. Some sponsors brought out products focusing on just a single factor such as yield, volatility, or momentum. Others put together various combinations of multifactor ETFs.

“Earlier this decade, Towers Watson coined the term “smart beta” as a way to identify good investment ideas that can be structured better. Although the descriptive accuracy and the actual definition are subject to debate among investment professionals, the term has caught on in the financial world. As a result, smart-beta investing is becoming more mainstream every day.

“Today, sponsors are rolling out multifactor smart-beta ETFs by the truckload. Low volatility and dividend yield have been two well-performing factors the past few years. As a result, there is an abundance of new offerings combining these two factors. Other sponsors are diligently searching for the “best” combinations of four, five, six, or more factors to package into a single product.

“However, these products all tend to overlook one thing: factors rotate. Just like various sectors come into and out of favor, so do investment factors. In the late 1990s, earnings momentum was the dominant factor. After the dot-com bubble, the value factor was king. Eight years ago, as the financial crisis was unfolding, yield became the prime factor.

“For the past six weeks, beta has been the primary factor driving performance, and a portfolio constructed of high-beta stocks would have likely outperformed most other methodologies. Investors wanting to exploit this concept can use single-factor ETFs such as PowerShares S&P 500 High Beta (SPHB) to their advantage. SPHB owns the 100 stocks from the S&P 500 Index with the highest 12-month beta. The ETF has outperformed the SPDR S&P 500 ETF (SPY) by about 8% since June 27 (about six weeks).

spy chart

“Be sure you have an exit plan before you run out and buy it though, because SPHB underperformed SPY by 14% in 2015 when the beta factor was out of favor.”

Ron Rowland, All Star Investor, www.AllStarInvestor.com, 800-299-4223

Wall Street’s Best Editor Note:

Instead of the traditional capitalization-weighted indexes, smart Beta ETFs use alternative weighting strategies, such as size, value, momentum and volatility. The funds combine passive and active investing in order to enhance returns, decrease risk and add diversification, while minimizing costs.

The following graph depicts the popularity of the genre, showing the number of smart Beta ETFs that have been created since 2012.

graph

And this chart is a compilation of various statistics summarizing the industry.

industry chart

As Ron notes, smart Beta ETFs offer investors some interesting—and growing—options, but remember, the market has shown us over and over again that one strategy is not fail-safe for all markets. Consequently, flexibility to alter your strategy as needed is an essential key to investing success.

Happy investing,


Nancy Zambell
Editor, Wall Street’s Best Investments and Wall Street’s Best Dividend Stocks

Nancy Zambell has spent 30 years educating and helping individual investors navigate the minefields of the financial industry. She has created and/or written numerous investment publications, including UnDiscovered Stocks, UnTapped Opportunities, and Nancy Zambell’s Buried Treasures under $10. Nancy has worked with MoneyShow.com for many years as an editor and interviewer for their on-site video studios.