Smart Beta For Downside Protection

November 18, 2015

Is there a smart-beta fund you bought in 2015 you didn’t own before? What are some of your favorites right now?
Right now growth is outperforming value, so we’ve used the iShares S&P 500 Growth ETF (IVW | A-93). We’ve also used the iShares MSCI USA Minimum Volatility ETF (USMV | A-72). These are two funds we typically use in the large growth area.

In the international segment—where it’s been crazy in terms of volatility—we’ve used the iShares MSCI EAFE Minimum Volatility ETF (EFAV | A-61). We’ve also held a small position in the EGShares Emerging Markets Consumer ETF (ECON | C-45) for emerging markets, which are even more volatile.

Again, at Miracle Mile, we’re not day traders by any stretch of the imagination. We try to figure out long-term trends, and that enables us to employ smart-beta strategies in that.

How do you measure if your smart-beta picks are right? Is it solely based on performance?
There’re two things we look at. When we employ smart-beta ETFs, I look at it as an opportunity cost. When we substitute a smart-beta strategy for a market-cap index ETF, for example, there’s an opportunity cost with that. And that’s going to be performance. You’re either going to outperform or underperform.

The time frame in which you employ that strategy is going to be of consequence, too. If you’re greatly underperforming, then maybe you have to reconsider. Or maybe you don’t, because you have further conviction that, over time, you’ll be right.

The other way we look at whether a smart-beta strategy is working is in terms of volatility. If you find that a traditional market-cap-weighted ETF you use is displaying volatility that’s so great it’s having a negative bias on the overall performance of your portfolio, you might want to use a smart-beta strategy instead to maintain exposure to that asset class but manage volatility.

Performance and volatility are two of the things we measure in using a smart-beta strategy.

What are the biggest drawbacks to using smart-beta ETFs?
There are different types of risks. I’d say that the No. 1 issue is you have to have realistic expectations. Just because it’s called smart beta doesn’t mean it’s smart all the time, or that it actually encompasses beta. Investors really need to expect that smart-beta strategies are going to go through poor return periods, and they’re not the end-all for all. You must have realistic expectations.

Another issue is tracking. Some of these exchange-traded products tracking indices may be thinly traded and have wide bid/ask spreads, which makes these smart-beta ETFs more costly to trade. Excessive turnover and implementation costs will also impact returns.

Another risk in smart beta is liquidity. Smart-beta strategies, by their very nature, tend to display increased exposure to value and small-cap stocks relative to the cap-weighted index. That could potentially increase liquidity risk due to the generally less liquid stocks in those particular segments.

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