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.

Understanding Factor Loadings

Suppose you hold a broad, market-cap-weighted U.S. large-cap portfolio. You then overlay a long/short value portfolio (i.e., a portfolio that is long undervalued stocks and short overvalued stocks) on top of the standard market exposure. The factor loading represents the size of the allocation to this long/short portfolio.

As an example, IWD has a value factor loading of 0.37. This implies that IWD, very roughly speaking, consists of an allocation to the market plus a 37% allocation to a value long/short portfolio. (Note: This is highly simplified, for a number of reasons.)

In our ETF selection process, we prefer ETFs with high loadings to our selected factors. The rationale for this comes down to simple math.

Assume you have two value ETFs: ABC and XYZ. Both ABC and XYZ have betas of 1.00. The value factor loadings for ABC and XYZ are 0.20 and 1.00, respectively. Let's also assume that neither ETF has exposure to any other factors.

For XYZ to outperform the market by 1%, undervalued stocks would only need to outperform overvalued stocks by 1%. However, ABC would need this undervalued/overvalued spread to rise by a full 5% to generate 1% of outperformance since it has so much less exposure to value. In our view, XYZ gives us more bang for our buck.

What Factors Are Creeping In?

Understanding factor loadings is crucial to making sure expectations and experience align. However, we cannot just focus on the one factor we want exposure to; we need to check whether any other factors are creeping in to the ETF's weighting methodology.

One ETF we really like in the value space is the Guggenheim S&P 500 Pure Value ETF (RPV | A-61). We like it because it has a high-value loading, but also because it's neutral to the other factors. Size is the one exception here, but this really stems from the fact that the ETF weights its holdings by value score, so it has a bias toward equal-weight. This weighting methodology is part of the reason the ETF can achieve such a high-value loading, and so it is a necessary evil.

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

ETF investors fret over things such as fees and tracking error in a vacuum, and lose sight of the big picture.

If you are going to do that much research, you might as well get the upside of gaining exposure to the factor in the appropriate way. Factors, just as with styles and philosophies, by default must go in and out of favor over time to persist (see our basis for this thought in this article), so investors must be committed to an approach.

The easiest way to do that is to initially select the proper exposure.

At any given time, Newfound Research LLC may be allocated to any of the ETFs referenced in this article. Newfound is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call 617-531-9773, visit www.thinknewfound.com or email [email protected]. For a list of relevant disclosures, click here.

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