The ETF industry has traditionally been dominated by products based on market capitalization weighted indexes that are designed to represent the market or a particular segment of the market. Market cap weighted indexes work great for investors who believe in market efficiency. They provide a low-cost, convenient and transparent way of replicating market returns. (Read: 3 Niche ETFs Crushing the Market)
On the other hand, some investors who believe that it is possible to beat the market by superior stock selection opt to invest through active managers. However, returns generated by actively managed funds do not always justify the higher costs associated with them.
Many retail investors are not aware about another class of funds that adopt the “middle path” of tracking non-cap weighted strategies--popularly known as “Smart Beta”. Many analysts do not agree with the word “Smart” and prefer to call them “Alternative” or “Advanced” beta strategies. (Read: 3 Growth ETFs for a Continued Small Cap Surge)
What is Smart Beta?
These indexes attempt to select stocks that have better chances of risk-return performance, based on certain fundamental characteristics or a combination of such characteristics. So in simpler words, it is like starting with the same set of ingredients but adding a twist to the traditional recipe by changing the proportion of ingredients to enhance the taste and flavor of the dish.
While not so popular with retail investors yet, these strategies have already become very popular with institutional investors. Per some estimates, "Smart Beta" products may attract about one-third of global institutional equity allocations by 2018. (Read: 3 ETF Winners from the No-Taper shocker)
Do Smart Beta Strategies Deliver Smart Results?
Increasing interest in these strategies is a result of their better performance compared with cap-weighted funds, usually at a much lower-cost than actively managed funds. Backtested results on 13 alternative indexes for the period from 1968 to 2011 show that while the market-cap index generated a 9.4% annualized return, alternative indexes delivered between 9.8% and 11.4% annualized return. (Read: Beat Hedge Funds with these ETFs)
While this space offers a number of choices to investors, including simplest equal-weighting, fundamental weighting and volatility/momentum based weighting methodologies, not all these strategies have been able to deliver superior results. Below we have highlighted three options that have delivered better results than their market-cap weighted counterparts consistently.
PowerShares FTSE RAFI US 1000 Portfolio (PRF - Free Report)
PRF is based on RAFI index that aims to select stocks based on four fundamental measures viz, book value, cash flow, sales and dividends. The 1,000 equities with the highest fundamental strength are weighted by their fundamental scores.
Exxon Mobil, Bank of America and GE are among the top holdings but the asset base is pretty well spread out, with top 10 holdings accounting for just 18% of the total.
PRF has returned 143.4% in the last five years compared with 94.2% for the iShares Russell 1000 ETF (IWB) and 114.3% for SPDR S&P 500 ETF (SPY).
The product charges an expense ratio of 39 basis points and has a daily trading volume of about 115,000 shares.
S&P 500 Low Volatility ETF (SPLV - Free Report)
Though the low-volatility concept is relatively new in the ETF universe, it has become extremely popular of late. SPLV was the first product in this space and is so far the most popular, with more than $3.8 billion in assets. The product is based on the research that low-volatility stocks have produced better risk-adjusted returns in all markets over long-term.
SPLV tracks the performance of 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months. The ETF currently has an attractive 12-month yield of 2.8%, while it charges a low expense ratio of 0.25% per year.
In terms of sector allocation, Utilities (25.7%), Consumer Staples (19.4%) and Financials (18.2%) take the top three spots. The fund is pretty spread out in terms of individual holdings with the top holding J&J accounting for just 1.3% of the assets.
While the product underperforms the broader market in strong bullish periods due to its focus on defensive stocks, it has managed to beat the broader market since its inception, while keeping the risk at a much lower level.
Looking at the longer term performance of the index, S&P Low Volatility index had an annualized total return of 14.5% compared with 13.9% for the S&P 500 Total Return index.
Guggenheim S&P 500 Equal Weight ETF (RSP - Free Report)
Equal weighted indexes are the simplest form of Smart Beta indexes. This fund tracks the S&P Equal Weight Index, putting roughly 0.2% in each stock. The success of the product is mainly a result of its greater focus on mid-cap stocks compared with the market-cap weighted index.
From a sectors perspective, the fund assigns almost equal weights (16.3%) to Consumer Discretionary and Financials, while Information Technology, industrials and healthcare also have double-digit allocations.
The ETF charges 40 basis points in fees per year from investors, and has managed to attract $5.2 billion in total assets. With a decent daily volume of 750,000 shares, the bid/ask spread are usually tight.
RSP has returned 25.3% year-to-date basis, compared with 21.3% for SPY. Looking at the longer-term, RSP has returned 147.4% compared with 114.3% for SPY in the trailing five-year period.
Not all "Smart Beta" funds have outperformed their market-cap weighted cousins. Further they usually have slightly higher expense ratios and also come with higher trading costs. But some of them have been consistently delivering better results and are worth a look.
To begin with, investors should use products based on simpler and more transparent alternative methodologies that are easier to understand.
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