How To Pick The Right Smart Beta ETF

April 21, 2016

This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Andrew Gogerty, vice president of investment strategies at Boston-based Newfound Research LLC.

Whether you call it strategic beta, factor investing or smart beta, the crop of alternatively weighted ETFs has been the hot spot for equity investing recently.

Weighting schemes, index philosophies and discovery of new "factors" have exploded more than the azaleas on Magnolia Lane at the Masters.

Oftentimes in the face of overwhelming options, the default tendency is to diversify. Sometimes this type of diversification is good and sometimes it's bad. That's an important topic, but not the focus of this perspective (it's been covered by my colleagues in a perspective here).

Instead, we are starting with the premise that an investor or advisor has selected a factor and is looking to incorporate that factor into the portfolio with an ETF.

Know What You Own

As we noted in a recent ETF.com article on small-cap exposure, it is crucial to know what you own. As Warren Buffett once quipped, "Risk comes from not knowing what you're doing."

Say you want exposure to the value factor. The risk may be that you don't dig in to the index methodology, failing to uncover a fundamental flaw in the portfolio construction. Or it may be that you choose a value ETF without understanding just how exposed that ETF is to value.

Continuing with our value example, investors must understand the true loading or exposure of an ETF to a factor. Sure, seems simple enough. But the number of ETFs purporting to offer exposure to a particular factor has exploded. Below, we present examples of value ETFs and their actual exposure to the value factor.

Source: Data from ETFdb.com, AQR, and Yahoo Finance. Calculations by Newfound Research. Data from March 2006 to November 2015.

 

This is just one example, but the takeaway for any exposure is to know what you own. This means understanding the methodology, the portfolio and the factor exposures. At Newfound, once we decide we want to own a given factor, we look to select ETFs with higher loadings to that factor. In other words, we commit to owning the factor.

Much as most investors don't want their active manager to be a closet index, few would be happy thinking they are exposed to the value factor but come to realize that, in fact, their position was really just a closet broad market fund.

To understand why this is important, it's important to understand what the factor loadings in the graph above mean.

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