Finding Robust Smart Beta Solutions

February 25, 2015

[The following "ETF Issuer Perspective" is sponsored by ETF Securities]

 

Smart Beta: Factors & Weights

Prior to 2008, numerous hedge funds affirmed that their strategies were supposedly uncorrelated to the performance of the S&P 500. The financial crisis that followed brought a different story. The current evolution of smart-beta indexes seems to be a repeat of this period, where any nonmarket-cap-weighted strategy is called a "smart beta" index, which makes it quite challenging for investors to select a particular model.

 

Smart-beta indexes should directly address the historical limits of market-cap indexes. Based on this premise, investors should then be able to review any "smart beta" model by focusing on two questions:

  • What potential issues linked to market-cap-weighted indexes does the model try to address?
  • Are the solutions effectively designed to address those issues?

 

Distinguishing the potential issues with market-cap-weighted indexes

There are two very distinct criticisms of market-cap-weighted indexes:

  1. Factor tilt: Market-cap indexes naturally tilt exposure toward (i) growth stocks; and (ii) the largest market-cap stocks. However, in 1993, Fama and French showed that a portfolio tilted toward small-cap and value stocks would have had outperformed the market.
  2. Concentration: It is generally expected that most indexes seek to provide well-diversified exposure. Interestingly though, market-cap-weighted indexes can be considered as not properly designed to do so. For instance, the top 25 percent of holdings in the S&P 500 have generally represented more than 68 percent of the index performance. Academic research (Haugen and Baker, 1991; Cochrane 2001; and Goltz 2010) has shown that this potential overconcentration can lead to a suboptimal risk/return profile.

 

Two distinct issues and two distinct solutions

Addressing the factor tilt issue

Factors are determined by their ability to provide risk-adjusted outperformance. To determine how robust a factor model is, one should focus on the following two aspects:

  • Empirical evidence: Ideally, the performance analysis for a given factor should be carried over an extensive period of time
  • Economic rationale: A factor model should not be a data-mining exercise, and the selected factor should have a strong economic basis

 

Based on the current status of academic research, there is overall agreement on four key factors.

 

 

One should be conscious that each factor can be quite cyclical. Because of this, combining factors should help improve long-term risk-adjusted returns.

 

 

Addressing the diversification issue

Tilting a portfolio to a particular factor does not fix the concentration issue. For instance, the FTSE RAFI 1000 US index, which is described as "a fundamentally weighted index," tilts exposure toward value. However, the 25 percent largest stocks in that index generally represent more than 77 percent of index performance, i.e., a higher concentration than the S&P 500. Applying the modern portfolio theory,[1] investors should look for solutions to diversify their exposure to potentially improve their risk/return profile. On the other hand, investors should be conscious that a pure reweighting exercise, without targeting a particular factor, can lead to unintended consequences. For instance, the S&P 500 Equal Weight (EW) Index generally results in a tilt toward smaller-cap stocks and the highest-volatility stocks, which may make the index more volatile compared with other large-cap indexes.

 

 

A potential solution: Smart Beta 2.0

The Edhec Risk Institute (ERI) is an academic institution focusing on applied research for the investment industry and is widely followed among large institutions; in particular, pension funds and endowments. In 2012, ERI Scientific Beta was created with the objective of bringing scientific rigor to smart-beta indexes. Their solutions aim at addressing the potential issues of market-cap-weighted indexs by distinguishing factor exposures and weighting strategies.

 

 

 

ETF Securities is the first provider in the U.S. market to offer products tracking indexes from ERI Scientific Beta:

  • ETFS Diversified-Factor U.S. Large Cap Index Fund (SBUS)
  • ETFS Diversified-Factor Developed Europe Index Fund (SBEU)

 

These ETFs seek to provide broad market exposure by combining the four current well-established previously disclosed factors, while the weighting strategies aim to maximize the exposure with a goal of improving overall risk adjusted performance.

 

For more information on the exchange-traded funds, please refer to our website at etfsecurities.com/ScientificBeta.

 

ETFS Diversified-Factor U.S. Large Cap Index Fund (SBUS) seeks to track the price and yield performance, before fees and expenses, of the Scientific Beta United States Multi-Beta Multi-Strategy Equal Weight Index (the "Index").

 

ETFS Diversified-Factor Developed Europe Index Fund (SBEU) seeks to track the price and yield performance, before fees and expenses, of the Scientific Beta Developed Europe Multi-Beta Multi-Strategy Equal Weight Index (the "Index").

 

Endnote

  1. Modern portfolio theory is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.

 

 

Disclaimer

An investor should consider the investment objectives, risks, charges and expenses of the ETFs carefully before investing. To obtain a prospectus containing this and other important information, call 1-212-918-4954 or 844-ETFS-Buy (844-383-7289) or visit www.etfsecurities.com. Read the prospectus carefully before investing.

 

Fund Risk: There are risks associated with investing including possible loss of principal. The prices of the securities in which the Funds invest may decline for a number of reasons, including in response to economic developments and perceptions about the creditworthiness of individual issuers. Investments in non-U.S. securities involve certain risks that may not be present with investments in U.S. securities. For example, investments in non-U.S. securities may be subject to risk of loss due to foreign currency fluctuations or to political or economic instability. The Funds do not attempt to outperform an Index or take defensive positions in declining markets. Past performance does not guarantee future results. There can be no assurance that the Funds' investment objectives will be achieved. Please read the Funds' prospectus for specific details regarding the Funds' risk profile.

 

The Scientific Beta United States Multi-Beta Multi-Strategy Equal-Weight Index and the Scientific Beta Developed Europe Multi-Beta Multi-Strategy Equal-Weight Index are the intellectual property (including registered trademarks) of EDHEC Risk Institute Asia Ltd and/or its licensors, which is used under license within the framework of ERI Scientific Beta activity. The ETFS Diversified-Factor Large Cap US Index Fund and the ETFS Diversified-Factor Developed Europe Index Fund that replicate fully or partially the Scientific Beta United States Multi-Beta Multi-Strategy Equal-Weight Index and the Scientific Beta Developed Europe Multi-Beta Multi-Strategy Equal-Weight Index are not sponsored, endorsed, sold or promoted by EDHEC Risk Institute Asia Ltd and its licensors and neither EDHEC Risk Institute ASIA Ltd nor its licensors shall have any liability with respect thereto.

 

ETFS Diversified-Factor U.S. Large Cap Index Fund (SBUS) and ETFS Diversified-Factor Developed Europe Index Fund (SBEU) trade on the NYSE Arca, Inc.

 

The S&P 500 Index is a capitalization-weighted index of 500 stocks selected by the Standard & Poor's Index Committee designed to represent the performance of the leading industries in the U.S. economy.

 

The S&P 500 EW Index is a constituent equal-weight version of the S&P 500.

 

The FTSE RAFI 1000 US Index uses specific fundamental factors that weights index constituents rather than market-cap.

 

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

 

A smart-beta index is an index designed to outperform a widely followed market-cap-weighted benchmark index normally by altering the constituent weights.

 

Modern portfolio theory is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.

 

Mike McGlone, CFA, Director-Research, ETF Securities, is a registered representative of ALPS Distributors, Inc.

 

The ETFs are new products with a limited operating history.

 

Indexes are unmanaged and one cannot invest directly in an index.

 

Investors buy and sell shares on a secondary market (i.e., not directly from the Trust). Only market makers or "authorized participants" may trade directly with the funds, typically in blocks of 50K to 100K shares.

 

ALPS is not affiliated with ETF Securities or EDHEC Risk Institute ASIA Ltd.

 

ALPS Distributors, Inc. is the distributor for the ETFS Trust.

 

ETFS 000725 12/31/2015

 

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