Often when markets are climbing, investor confidence follows suit. And while investors continue to enjoy one of the longest bull runs in history, engaged investors should always be thinking about what they will do when the good times come crashing down.
Traditionally when markets go south, investors have looked to a more conservative fixed-income based portfolio. But in a rising rate environment and an investment landscape challenged by ongoing trade and geopolitical uncertainty, a traditional fixed-income allocation may no longer be enough to meet an investor’s investment goals.
It’s not all doom and gloom for investors. With traditional approaches increasingly struggling to meet investor expectations, we are instead seeing a growing number of investors harness the opportunities of multi-factor smart beta exchange traded funds (ETFs).
Smart beta is an investment strategy that harnesses the drivers of equity risk and returns, or ‘factors’, a style of investing typically adopted by active managers, which result in an investment portfolio that aims to be more responsive to market cycles. With a growing number of multi-factor smart-beta ETFs now available to Australian investors, it has never been easier to access these opportunities.
Understanding Factors
In comparison to traditional index investing, smart beta represents an evolution in indexing. ETFs are often described as baskets of securities that track a particular index. In comparison, rather than weighting stocks by market cap, multi-factor smart beta indices are constructed to identify specific factor exposures.
From a traditional index perspective, smart beta investing is an easily replicated, transparent, rules-based and cost-effective approach within a wider investment universe. Yet multi-factor smart beta ETFs also require investors to understand how different factors will interact and perform in their investment portfolios.
There are six common smart beta factors that can drive portfolio returns, expanded on below:
Value: Value stocks are those that trade at a low price relative to their fundamentals (earnings or sales). Over the long-term value stocks have been shown to outperform the broader market indices.
Quality: Quality focuses on companies with low debt, stable earnings and high profitability. We tend to see higher quality companies rewarded with higher returns over the long-term because they have been shown to be better at deploying capital and generating wealth than the broader market.
Size: Small-cap stocks tend to outperform their large-cap peers over time. It’s argued that some of this outperformance can be attributed to fewer analysts covering small-cap companies, giving them more room to surprise the market on the upside. Another argument is that small-cap stocks may be higher risk than their large-cap counterparts.
Low volatility: While the risk return relationship holds between asset classes, within the equity asset class low volatility securities have been shown to deliver a higher risk adjusted return than more volatile securities.
Momentum: Empirical evidence shows us stocks that have done well recently may have greater potential of doing well in the near term than the broader market, and similarly stocks that have done poorly are more likely to continue to do poorly in the near term. Gaining or avoiding exposure to these stocks could potentially result in a portfolio that benefits from the momentum premium.
Yield: Over the long-term, stocks with higher dividends tend to perform better than stocks with lower yields. This outperformance could be attributed to either the value or quality characteristics of the yield.
With such wide-ranging attributes, it shouldn’t be a surprise that these factors perform differently in different market conditions. For example, quality and low volatility strategies tend to outperform in market downturns, while value strategies often deliver their best returns in a risk seeking environment.
Why a multifactor approach?
Factors have long been harnessed by investors looking to beat the benchmark and grow their portfolio returns. Smart beta is the vehicle that enables investors to deploy tactical strategies to both diversify and reduce their portfolios potential risks – all in a transparent and cost-effective way.
The multifactor smart beta approach allows investors to use an index that has been specifically designed to screen for desired factors. Importantly, it is this rules-based approach that can help investors to potentially achieve both positive exposure to their desired factors and cost reduction through the ETF structure.
Thomas Reif, global portfolio strategist, State Street Global Advisors
