Smart-Beta ETFs: The Risks You Want

March 06, 2014

Smart beta isn’t smarter than cap weighting, but it is different, and that’s good.

 

The topic of smart-beta ETFs loomed large at the 2014 Inside ETFs conference and continues to resonate with a recent Bloomberg article and a Rick Ferri blog.

The Bloomberg article notes that smart-beta ETFs have grown in popularity despite their higher fees, and Ferri’s piece rightly points out that these products are often riskier than “plain vanilla” market-cap-weighted ETFs.

My own view is simple: Smart-beta products allow you to take the risks you want.

To be clear, I don’t believe smart-beta ETFs systematically beat the market. I also agree that their higher costs must be carefully weighed, especially considering the stiff competition: Plain-vanilla ETFs excel at delivering market risk at an extremely low all-in cost and in a tax-efficient, transparent wrapper.

But I also believe that not every investor wants pure-play market risk. As the old saying goes, investing is about eating and sleeping: You need returns to eat, but you also need peace of mind to sleep at night.

In other words, not every investor feels most comfortable riding the exact path laid down by the S&P 500 Index.

As an alternative, I see the appeal of fundamental ETFs like the PowerShares FTSE RAFI US 1000 Portfolio (PRF | A-86). PRF strips a stock’s price out of the equation and instead allocates based on each firm’s economic footprint.

As such, the fund is likely to sell off a hot stock, unless that stock is backed by strong cash flows, dividends, revenue and book value. This should attract investors who take a dim view of stocks with three-digit price-earnings multiples.

I also like the Guggenheim S&P 500 Equal Weight ETF (RSP| A-73) because of its systematic rebalance to equal weight: It sells off the winners and buys stocks when they’re cheap. This approach should resonate with contrarians.

Still, PRF and RSP take more risk than funds like pure-play index funds like the SPDR S&P 500 ETF (SPY | A-97).

Market-cap-weighted funds like SPY favor the largest firms, which tend to be less risky. In contrast, equal-weighted funds like RSP hold smaller, riskier firms in greater proportion relative to SPY.

RSP’s elevated market risk shows up as high beta of 1.08. This means RSP will likely beat SPY in good times and lag in bad times.

 

 

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