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3 ways smart beta can enhance your portfolio

By James Dunn

The first exchange-traded funds (ETFs) offered investors ‘beta’ – the return of a market index representing a particular asset class. Therefore, ETFs allowed investors to improve diversification in their portfolios – filling gaps with cost-effective, simple, instant and liquid exposure to different markets and asset classes.

The initial use of ETFs in retail portfolios was as simple buy-and-hold passive exposure to a chosen asset class. Investors found them particularly suitable to “core-satellite” strategies, where the ETFs formed the portfolio core, established to garner the beta of a particular asset class, while satellite strategic decisions were put in place to pick up alpha, or return above the beta. 

What is smart beta?

As ETF issuers have developed products to target specific investor needs, ETFs offering particular strategies (for example, high-dividend-yield stocks) or investment styles, have become popular. Prevailing market volatility and low yields have driven many investors to search for an investment approach that better aligns with their needs. 

Strategic ETFs are designed to deliver “smart beta,” which is an approach based around capturing investment “factors,” or market inefficiencies, in a rules-based, transparent manner. 

Factors have been identified for many decades as fundamental underlying drivers of return. These factors could be macro-economic, such as the pace of economic growth and inflation, which can explain returns across asset classes like stocks and bonds: alternatively, these factors could be “style” factors (for example, “value” or “quality”) which help to explain returns within asset classes.

In effect, smart beta ETFs are built around a different index to the traditional market-capitalisation-based indices, with the index designed to harvest a different return. That allows heightened diversification, as well as the opportunity to earn enhanced, risk-adjusted returns. 

Smart beta is a strategy that involves following an index designed to capitalise on inefficiencies in the market. Smart beta ETFs sit between active and index investment approaches, incorporating elements of both. 

The three major smart beta strategies used in equity ETFs are: 

1. Low volatility - Protect yourself from market shocks 

Low-volatility ETFs take the broad stock index and choose from the stocks that show the lowest historical volatility – that is, they fluctuate in price less than the overall index. 

Lower-volatility stocks tend to be more mature companies that are less dependent on continued economic growth – such stocks also tend to have higher-than-average yields. They tend to fall by less in market downturns, but they also tend not to rise as much in market rallies. 

The theory behind low-volatility ETFs is that they give the investor roughly the same equity exposure as a broader equity ETF, but in a form that helps a nervous investor sleep better at night. The lower volatility means that over the long run, the investor is less likely to be panicked out of their investment in the stock market. 

Low-volatility ETFs have become very popular in the US market, where a number of risks have been identified. 

The first is that the strategy is in danger of becoming a classic “crowded trade.” That’s when the individual stocks are bid to higher valuations than they would otherwise justify, and the very success of the low-volatility ETFs in attracting money actually increases the likelihood of lower risk-adjusted returns going forward.

The second is the fact that the low-volatility ETFs have tended to cluster in similar stocks: as a group they are heavily weighted in financial, consumer staples, health care, utilities and telecom stocks. Despite low volatility ETFs capping exposure to these sectors, US analysts have noted that these sectors often behave like bonds, doing best in periods of falling interest rates. With the US Federal Reserve expected to lift interest rates in 2017, it may be an inopportune time to buy low-volatility ETFs.

2. High-dividend yield: Target higher income

As the term suggests, high-dividend-yield ETFs target higher levels of equity income while being diversified across sectors. To avoid ‘dividend traps’ (companies where the yield appears artificially high because the share price has fallen) the high-dividend-yield is biased to companies that have a strong track record of paying a rising dividend stream, through consistent earnings growth. 

The strategy ensures that any high yield is not due to a large one-off dividend and that the companies have the capacity to increase their dividends, through a sustainable payout ratio. 

In the Australian context, these stocks also deliver a high level of tax-effective franking credits and are therefore seen as particularly attractive investments for retirement portfolios and self-managed super funds (SMSFs). 

In the US, there’s a wide variety of criteria used by high-dividend ETFs. For example, some focus on companies that consistently raise their dividends, not simply stocks with high yields, some apply other financial strength measures such as return on equity (ROE), while others equally weight the portfolio to the highest yielders in each sector of the S&P 500 Index. 

In the Australian context, high-dividend yield ETFs run the risk of high concentration risk. They will be biased to the big four banks (Westpac, ANZ, National Australia Bank, Commonwealth Bank of Australia) and Telstra, and the real estate investment trusts (REITs) that pay large distributions. The portfolio is likely to be overly influenced by the performance of the Australian finance sector. US high-dividend-yield ETFs do not have this problem, a legacy of the financial crisis, which forced many banks to cut dividends or, at best, maintain them.

High-dividend-yield ETFs also run the risk of bidding up the target stocks. 

3. Outperformance: using style factors to beat the market

Over long periods of time in the stock market, ‘style’ factors have demonstrated the ability to earn higher long-term returns than the broad market indices, while bearing level of risk to a broad market investment. Because they’re driven by different market characteristics, these factors can be most rewarded in different market environments, and points in the economic cycle. 

For example, company ‘quality’ is usually assessed on fundamental financial criteria such as balance sheet strength, low debt levels, record of consistent earnings and dividend growth, high return on equity (ROE), profitability, management efficiency, consistently rising cash flow generation, high dividend payout ratios and sustainable competitive advantage.

The term “quality” generally denotes companies that historically have weathered economic and market downturns better than other stocks. Quality stocks, traditionally, have their strongest relative performance late in the economic cycle, when earnings are deteriorating, or in actual recessions. Quality can also be considered a defensive attribute - it has tended to only under-perform, on a relative basis, during stronger economic times.

‘Value’ stocks are considered cheap because they are out favour with the market and are consequently priced low, relative to the company’s earnings or assets. A value stock is usually considered to have a relatively low price/earnings (P/E) ratio and a low price-to-NTA (net tangible assets) value, but a high dividend yield (because its price has fallen). Value investors look for such value anomalies and buy the stock because they believe that the market will eventually recognise its true value and the stock will be re-evaluated (bid up in price). ‘Value’ stocks tend to outperform early in the economic cycle.

‘Size’ refers to market capitalisation, or the value of the company’s equity on the stock market at any time. Small caps – or small market capitalisation companies – generally tend to outperform their larger counterparts, for a range of reasons. They often have high growth rates, there is often an ‘information gap’ because they are poorly covered by analysts: this can lead to a valuation gap, and as these gaps are filled, the small-cap stocks can appreciate in value quite quickly. 

Small, high-growth companies are often more nimble than their larger counterparts, and tend to outperform them, especially in the early stages of economic recovery, and in rising interest-rate environments. 

(There is no universal definition for “small capitalisation,” which differs from market to market: in Australia, for example, “small caps” usually refers to stocks in the S&P/ASX Small Ordinaries index, which have a market value of about $2 billion or lower.)

Lastly, ‘momentum’ stocks – where the stock price is changing quickly – can come into their own when the economy is growing strongly, toward the peak of the economic cycle. There is an empirically observed tendency for stocks rising in price to keep rising, and for stocks with falling prices to keep falling. Momentum investing seeks to ride this trend.

All of these factors can be used in a smart beta strategy. Smart beta ETFs are not a magic bullet – they do not offer a safer route to returns, nor can they be expected to always outperform traditional market-cap-weighted equity ETFs. But the benefits can include improved diversification, and the ability to capture a wider spread of risk premiums than broader ETFs. Smart beta ETFs can harvest risk premiums previously only available through expensive active strategies, in a cheaper way.

Disclaimer: This is a sponsored article by BlackRock Investment Management

Published on: Wednesday, March 01, 2017

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