Rebalancing Of Smart Beta ETFs Often Overlooked

March 08, 2017

Todd Rosenbluth is director of ETF and mutual fund research at CFRA.

With Vanguard’s latest expense reduction on market-cap-weighted index mutual funds and ETFs—matching in many cases the cost for similar iShares products—it is easy to forget that most asset managers are steering clear of this battlefield and focusing on an alternative approach.

At the end of January, there were more than 600 smart-beta ETFs with a combined $477 billion in assets, according to ETFGI, a consulting firm. These ETFs are constructed based on one or more fundamental and/or valuation attributes and are regularly rebalanced. As such, the holdings inside and related sector exposure can and will shift periodically.

In exchange, the fees for these products are at a moderate premium to market-cap-weighted ETFs, such as the 0.11% for the Vanguard Total World Stock Index ETF (VT), and thus warrant more regular scrutiny.

CFRA ranks 980 equity ETFs on a daily basis combining holdings-based analysis with ETF-level metrics. We assess the holdings from a valuation and risk perspective in addition to incorporating the expense ratio, the bid/ask spread and more.

Rebalancing As Risk Control

According to WisdomTree, the act of annually rebalancing constituents of its proprietary index is an important risk control. For the WisdomTree MidCap Earnings Fund (EZM), companies with share prices that appreciated at a faster rate than their fundamental improvement would typically be reduced. Meanwhile, constituents with improving earnings, but stable or falling prices, would be added to during the rebalance.

With its 2.70% increase to 20% of assets, the consumer discretionary sector experienced the greatest positive change in the November 2016 rebalance; Office Depot and Tegna were recent top-10 holdings in the sector. While both stocks are qualitative hold recommendations for CFRA, they are undervalued based on our quantitative fair value approach. In contrast, energy exposure fell by 4.70% to less than 1% amid a strong performance, despite weak earnings. EZM has a 0.38% expense ratio.

Meanwhile, the PowerShares S&P 500 Low Volatility Index (SPLV) is rebalanced on a quarterly basis to find the 100 stocks with the lowest volatility. Unlike EZM, which focuses on selling winning stocks and buying laggards, SPLV seeks those stocks with the strongest performance stability relative to the broader S&P 500 Index. Stocks that were added to the portfolio following the February rebalance included Alphabet and Oracle, two stocks with above-average A- S&P Global Quality Rankings, a metric based on historic dividend and earnings records, which is used for CFRA’s ETF rankings.

Exposure to information technology and consumer discretionary rose to 7% and 9%, respectively, up from 4% and 7% at its rebalance. Such moves narrowed the underexposure compared to the broader index. Meanwhile, the relatively high weights in utilities (19% vs. 22%) and real estate (4% vs. 6%) were trimmed. SPLV has a 0.25% expense ratio.


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