The justification for smart beta investing is pretty well known now: with traditional market-cap investing, you’re putting the most money into the largest stocks, and these stocks are often the most expensive.
Your portfolio also becomes overly concentrated. Currently the top 5 companies in the S&P 500 have the same weight as the smallest 245 companies in the index.
But if you focus on factors such as value, your portfolio will probably be more diversified and your performance may well be better than that of a traditional passive fund. And if not better, at least different.
But how do you pick your smart beta ETFs? How do you even decide which factors to focus on?
I heard a couple of answers at this week’s Inside ETF 2018 conference in Florida.
Beware of geeks bearing gifts
Brian Kraus of Hartford Funds thinks that simplicity is an important attribute. If you can’t easily understand the smart beta fund, that’s a big warning sign. You need to understand the factor or factors that the ETF is using, and how the ETF defines and uses these factors.
It’s also useful to think about where we are in the market cycle as different factors are likely to perform best at different points of the cycle, according to Michael Labella of QS Investors. So, for example, momentum works well when a market is booming; value is good when a market is in recovery mode.
Remember that if you want to reduce risk, momentum and value on their own aren’t likely to do that, as momentum and value shares tend to be more volatile than the market as a whole.
You should also consider whether you want to follow a multi-factor strategy. One advantage is that a multi-factor strategy can lead you to invest in cheaper shares via your chose ETF. Labella cited some recent figures suggesting that a low volatility US portfolio currently trades on a price earnings ratio of 24, but if you combine low volatility with a sustained income strategy, you have a combined rating of 17.
Labella also pointed that there are two ways of building a multi factor fund or portfolio. You can adopt a ‘top down’ or ‘bottom up’ approach. Top down means that you put 20% of your money into value, 20% into quality and so on. You can vary the percentages as you see fit.
With bottom up, you run a value screen which removes a bunch of stocks from your universe, then you do, say, the momentum screen and keep going through all the factors that you want to use.
Offensive and Defensive
Kraus thinks you need to think of ‘offensive’ and ‘defensive’ attributes. He says that offence, defense and fees are ‘three legs of the evaluation process.’
Kraus says it’s best to start with defense. In other words, think about reducing risk – looking at sectors, countries and companies.
In offence, you’re looking at factors which will hopefully boost your performance.
As for fees, it’s not necessarily the case that cheapest funds are the best, you should compare the fees with what the fund offers, especially its active share – how it differs from the plain vanilla index trackers such as S&P and FTSE 100 funds.
It’s crucial that you think holistically too. By investing in a momentum ETF, have you improved your portfolio diversification. If you’ve already got loads of Amazon and Facebook shares, maybe not. Focusing on value or multi-factor, for example, might do a better job on the diversification front.
Kraus also argued that investors and advisers need to look closely at how an ETF defines a particular factor. There’s plenty of different definitions of value, you should make sure that you’re happy with the definition and you think there’s a good chance that this value strategy will deliver you a good return.
So, in summary, think about risk as well as reward; don’t just focus on fees; and think about factor ETFs relate to the rest of your portfolio.