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 is by Mike Venuto, co-founder and chief investment officer of New York-based Toroso Investments.
The growth of smart-beta strategies has been staggering, but quite top heavy.
Meaning, most assets have flowed to factor-based strategies and dividends. I have written in the past about a subcategory of smart beta that I call characteristic indexes. These indexes highlight a business characteristic that active investors often seek through a passive vehicle.
Many of the ETFs that follow these indexes are categorized by ETF.com as “Alpha-Seeking.” These ETFs allow investors to access buy-backs, spin-offs or IPOs in a low-cost, tax-efficient manner.
The top-performing “alpha-seeking” ETF for the past two years has been the Direxion All Cap Insider Sentiment ETF (KNOW | B-77). KNOW remains my current top pick for “characteristic” or “alpha seeking” ETF, and here is why:
I started due diligence on KNOW with the index data because, like most smart-beta concepts, live ETF data was not available during 2008. This analysis begins by evaluating the Sabrient Multi-cap Inside/Analyst Quant-Weighted Index (SBRQAM), a business characteristic index that investors can obtain exposure to through KNOW.
The index incorporates four key business characteristics:
- Aggressive accounting practices
- Corporate insiders’ behavior
- Analysts’ earnings revisions
- A defensive overlay
The process, simplified, is as follows:
Step 1 – Forensic Accounting Component:
Starting with the 1,500 stocks of the S&P Composite 1500, eliminate stocks of companies with very aggressive accounting practices, as identified by Sabrient’s proprietary forensic accounting methodology.
Step 2 – Insider & Earnings Revisions Component:
Four quantitative factors are used to rank and winnow the remaining stocks after Step 1. At least one of these four factors must be positive for a stock to make this cut:
- Number of insiders making open-market purchases
- Percent increase in the holdings of the purchaser
- Number of positive analyst revisions
- Percent increase in analyst expectations
A quantitative overlay ranks the stocks from the first cut to 600 using a forward-looking “outlook score.” This score rewards strong historical and projected growth trends, low current and projected valuation, high quality of earnings, and favorable dynamics of Wall Street analyst estimates. The top 100 stocks from this second cut are used to populate the index.