8 ‘Smart Beta’ ETFs That Cut Unique Paths

June 16, 2015

[Editor's Note: "PowerShares International BuyBack Achievers Portfolio" has been corrected to "PowerShares BuyBack Achievers Portfolio."]

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, the third in a three-part series about “smart beta,” is by John Eckstein, chief investment officer and director of research at Astor Investment Management.

This is my third note on "smart beta" funds. This time, I’ll look at those funds that ETF.com classifies as "alpha seeking." Despite the fact that "alpha-seeking beta funds" is internally inconsistent, we’ll ignore linguistic niceties and see what these funds have to offer.

These are funds that select stocks based on a well-defined methodology that we hope will outperform passive indexes with either capitalization or factor weights. As most other ETFs have been devoted to replicating indexes, this is a much smaller universe.

Specifically, this third and final look at smart-beta ETFs will focus on the strategies that don’t fit neatly into any other categories I explored in the first two installments. In the first installment, I looked at dividend-focused funds, and in part II, I looked at nondividend smart-beta strategies.

I’m talking about funds like the PowerShares S&P 500 Downside Hedged Portfolio (PHDG | B-44): strategies organized around the VIX volatility index, or equity strategies organized with options overlays.

But before pushing onward, I’ll remind readers that my previous columns on smart-beta ETFs were hedged with warnings about extrapolating from backtests, and as far as that goes, I need to repeat myself here.

Setting Up The Comparisons

We only have index histories extending beyond the ETFs for six of our funds, but in five of six instances, the alpha after the index was defined is below the alpha for the index over its simulation period, adjusted for the ETF's fees.

The beta delivered seems to be about what was simulated on average. My conclusion is that investors should place as much emphasis on the economic rationale behind the funds as the performance, live or simulated. 

So, I selected just eight of the larger funds from the list of alpha-seeking ETFs on the ETF.com site. The table below shows the period from 2001 and 2010, to-date. The data here are based on the indexes underlying the strategies, but they are also adjusted for the current fees of the ETFs. Only four of the indexes go back to 2001. 


  1/2001 - 5/2015   1/2010 - 5/2015      
  Compund Annualized   Compund Annualized      
  Anual
Growth
Rate
Risk-
Adjusted
Returns
Worst
Draw-
Down
  Anual
Growth
Rate
Risk-
Adjusted
Returns
   
Index
Live
 
FPX 9% 0.46 -52%   20% 1.22   June 2005 IPOs
PBP 3% 0.28 -36%   7% 0.70   April 2002 Option writing
PKW 12% 0.79 -50%   19% 1.38   Dec. 2006 Buyback
CSD         20% 1.24   June 2006 Spinoffs
GURU         16% 0.97   June 2012 Track hedge funds
MOAT         15% 0.88   June 2012 Wide moat
PDP         17% 1.10   March 2007 Momentum
PHDG         7% 0.78   Nov. 2009 Buys VIX futures
                   
S&P 500 5% 0.35 -51%   15% 1.11      

Alpha-seeking ETFs, performance of index tracked by funds, adjusted for ETF fees. Sources: Bloomberg, ETF.com, Astor calculations.



Partial Hedge Strategies

The first two strategies give exposure to the stock market, but also attempt to take the worst of the sting out of extended down periods. The PowerShares S&P 500 Downside Hedged Portfolio (PHDG | B-44) is a strategy expected to protect investors somewhat during severe declines, while keeping a major exposure to the broad market.

PHDG is a fund that has done poorly of late, but I’m not sure it should be dismissed. This fund holds a mixture of stocks and products organized around VIX futures. 

Products organized around VIX futures are probably best thought of as insurance—a product with a negative expected return—like an insurance premium. In other words, it’s a product that could have large positive returns when you need them the most.

The mix of stocks and VIX futures is determined by the level and direction of actual and forecast volatility.

In addition to stocks and VIX futures, PHDG also will go to cash in the event of a sharp decline. The rules chosen for this strategy worked quite well in backtesting, with good profits simulated in 2008 and 2009. The exact flavor of volatility we have endured recently has not been amenable to its strategy.

Other Approaches To Downside Protection

Nevertheless, I think an investor worried about a crash, but uncertain about timing, should consider PHDG, or the Barclays S&P Veqtor ETN (VQT | B-44), which follows the same index. 

Meanwhile, the PowerShares S&P 500 BuyWrite Portfolio (PBP | A-68) is based on the Buy-Write index as calculated by the CBOE options exchange. The strategy embodied in the index buys the S&P 500 and writes (sells) calls against it.

The calls bring in a small premium at the expense of giving away some of the profit in sharply rising markets. The premium has provided a bit of a cushion when stocks declined dramatically. However, if we compare PBP with the S&P 500 over the period of 2001-2014, the drawdown was only reduced by about as much as the total return. 

That is, investors could simply have taken a smaller positon in the S&P 500, invested the released cash in bonds and have been better off overall. 



Specialized Equity Strategies

I also want to highlight two strategies that pick stocks according to criteria completely unrelated to familiar capitalization-based indexes.

The PowerShares BuyBack Achievers Portfolio (PKW | B-95) is based on the Portfolio Nasdaq US BuyBack Achievers Index. This ETF invests in companies that have been making significant buybacks. This strategy ends up selecting stocks that would score well on multiple screening factors.

That means not just attractively valued smaller stocks, but also those that are robustly profitable with conservative balance sheets. This buyback index—adjusted for fees of the ETF—has done quite well compared with the S&P 500 Index since 2001.

In some ways, you can consider the First Trust US IPO ETF (FPX | B-75) the evil twin of PKW, which nevertheless finds its own way to make money. FPX stock tracks an index of recent IPOs. 

The companies that an investor can gain exposure to in this index are different than most other smart-beta funds in that the new companies listed these days tend to be over-leveraged, with less robust earnings history and somewhat overvalued compared with the market. 

Despite these apparent handicaps, the index has outperformed the S&P 500 since 2001, and slightly beat it in risk-adjusted terms. 

Takeaways 

Overall, there are fewer alpha-seeking funds, and they have shorter histories than the value or dividend-based funds we reviewed in parts I and II of this series. However, since these funds are trying to do something different than all the other me-too ETFs launched every day, they deserve a careful look by investors.


At the time this article was written, the author’s firm did not own any of the securities mentioned.

Astor Investment Management is a money manager with an active and economically grounded approach to asset allocation. We believe investment opportunities arise based on the ability to identify fundamental trends and changes in the economy. We build portfolios of ETFs appropriate for our analysis of the business and monetary policy cycles. For more information, see www.astorim.com; for our blog, see www.astorinsights.com.





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