Smart Beta For Downside Protection

November 18, 2015

[This article originally appeared in our November issue of ETF Report.]

Miracle Mile Advisors is an active indexer by design. The firm, started in 2007 by Brock Moseley, relies on the investing expertise of its several Wall Street veterans to deliver on one simple goal: protecting portfolios on the downside. As Scott Mullen, managing director at the firm, puts it, it is not a “buy and hope” shop.

That active-ETF-indexing style lends itself well to the use of smart-beta ETFs, which Mullen tells us help the firm in its pursuit of outsized returns. Miracle Mile currently manages about $500 million in assets.

Miracle Mile is known as an active indexer. What is "smart beta" to you?
Smart beta is really difficult to define, and it means a lot of things to a lot of different people. The simplest way to explain it is smart beta is any weighting methodology that is an alternative to the traditional market capitalization. This can include something simple, such as equal weighting, or it could place an emphasis on specific market factors like we see in dividends. Low volatility is a big smart-beta product. It also can include different revenue models, or momentum.

Conceptually, smart beta is designed to add value to investors and potentially increase their chances to get above-market returns without paying excessive fees, or taking additional risk.

Can you deviate from the market in search of outsized returns without taking on additional risk? Aren’t smart-beta ETFs inherently riskier?
Not necessarily, in my opinion. There are several risks associated with smart beta, but take a low-volatility strategy, for example. Risk is measured in multiple parameters; the most common being standard deviation. If you have a smart-beta product—such as an ETF that encompasses low volatility—you may find that in a market where volatility is high, a typical cap-weighted ETF may show a higher standard deviation or increased risk than the comparable smart-beta ETF in low vol.

How are you using smart-beta ETFs to capture outsized returns and manage risk?
Based upon a client’s risk parameters, we build ETF portfolios over your standard asset allocation. But we also have a tactical sleeve. For example, with the recent volatility going on in the markets, we’ve used some of the lower-vol and equal-weighted smart-beta ETFs to decrease the volatility on the overall portfolio. We’re really about lessening the risk of losing money over the long haul. It’s about managing the downside.

We’ve seen a proliferation of smart-beta ETFs in the last few years. Is having more vehicles to choose from good, or is it just diluting the concept of smart beta so that navigating the space is more difficult?
We have to be constantly aware of new trends in this space, because the market is growing greatly in this area. I read the other day that the use of smart-beta products is exceeding $500 billion in 2015—it was around $200 billion just in 2011. And approximately 53% of all institutional investors now use some sort of smart-beta product.

Being in the investment management business, it’s certainly in our best interest to be up on the product. But you’re right: Just because an area such as smart-beta ETFs is proliferating doesn’t necessarily make it good for the general investment landscape. Investors really need to have a clear, basic understanding of expected return, volatility in their portfolio and other types of risks associated with smart beta.

Is there an approach to smart beta that you prefer, such as factor-based or alternatively weighted? How do you find the right smart-beta ETF?
I like to use smart beta when I think a certain trend is going to last for a while. Take for example momentum, which encompasses a variety of different smart-beta products. If we have momentum in, say, small-cap stocks over large-cap stocks, or if we have momentum in growth stocks over value stocks, I might add some extra juice and try to attain some extra alpha through those strategies.

Conversely, in a market such as the one we’re in—where you have a lot of volatility—I may use an equal-weight or a low-volatility product. In fact, for several years, I’ve used the Guggenheim S&P 500 Equal Weight ETF (RSP | A-83) versus the SPDR S&P 500 (SPY | A-99). If you graph that over three years, you’ll see incredible outperformance by just that simple allocation.

That said, recently that has turned, and SPY is outperforming RSP. So you have to keep an eye on this, just like any other type of investment approach.

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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