This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Rusty Vanneman, CFA, CMT, chief investment officer of Omaha, Nebraska-based CLS Investments.
At CLS Investments, we are heavy users of smart-beta ETFs, so understanding smart beta is key to understanding CLS portfolios.
Smart-beta ETFs have become increasingly popular, but they are not always easy to explain. Though adoption rates by investors are quickly increasing, surveys show the leading reason adoption rates aren’t even higher is that investors are still trying to understand exactly what smart-beta ETFs are and what they’re used for.
Smart-beta (factor-based) ETFs are, technically, any ETF that is passively managed and weights its securities based on something other than market capitalization, like revenues or earnings. Put simply, smart-beta ETFs capture the essence of active management at a fraction of the cost.
Why Smart Beta Wins
They capture the essence of active management, because the factors that construct smart-beta ETFs are typically the same fundamental screens many money managers use when building portfolios.
All else being equal, lower cost always wins. Thus, smart beta is attractive because many investors use active management to achieve superior, risk-adjusted performance, but smart-beta strategies allow them to do so at a far lower cost.
While the average actively managed mutual fund has an expense ratio of more than 1% per year, the average smart-beta ETF has an expense ratio of approximately 0.3-0.35%, or about a third of the cost. That’s a good head start for better performance.
Better yet, factor investing—particularly when using the five global equity factors we focus on: quality, value, low volatility, momentum and small-caps—has provided an average annual excess return (above the overall market) of more than 2% a year for the last 20-plus years.
Best yet, these factors have performed even better in down years. Over the last 21 years, the MSCI All-Country World Index has had a negative return in six of those years. In each, the average factor has been higher for the year. The average excess return in those years was +4.6%.
Understanding smart beta is important, so we wanted to address some of the most common questions we get about it: