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. (Read: Best ETF Strategies for 2014)
However many investors now demand more than just market benchmark returns from their ETF investments and look for products that have the potential to beat the market. These 'Advanced/Smart Beta' ETFs attracted inflows of $46 billion last year, resulting in more than 20% increase in AUM.
Further most investors agree that stock market returns this year may not be as spectacular as last year’s. In fact returns will most likely be in high single to low double digit range. In such a scenario, the demand for products that aim to and have to potential to beat the market, while keeping the expenses low, will rise.
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. 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: 5 ETF Predictions for 2014)
Below we have highlighted three ‘Smart Beta’ options that we believe have the potential to beat the market in 2014. All these ETFs mostly focus on large-cap US companies, which will benefit from the brightening global growth environment. Also, most of these companies have huge cash piles on their balance-sheets and have been increasing dividends and buybacks. Going forward, they are likely to spend more on capital investments and hiring.
PowerShares FTSE RAFI US 1000 Portfolio (PRF - ETF 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 Chevron 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 186.1% in the last five years compared with 141.2% for SPDR S&P 500 ETF (SPY). (Read: Buy these ETFs to profit from the earnings season)
The product charges an expense ratio of 39 basis points.
iShares MSCI US Quality Factor ETF (QUAL - ETF report)
Academic research shows that high quality companies—as determined by factors such as high earnings quality and low leverage-- consistently deliver better risk adjusted returns than the broader market over long term.
QUAL tracks the MSCI USA Index, which is comprised of high quality stocks, by identifying stocks with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage. It charges a low expense ratio of 15 basis points.
The product holds 124 securities in its portfolio with Google, Exxon and Apple being the top three holdings. In terms of sectors, Technology takes about 40% of the asset base, while Consumer Discretionary, Energy, and Healthcare also get double digit allocations. (Read: 3 Best Dividend ETFs of 2013)
Launched in July last year, the fund has already attracted an impressive $285 million in assets so far. It returned 13.3% in the last six months compared with 10.6% for SPY.
RevenueShares Large Cap (RWL - ETF report)
Many analysts believe that revenues and not earnings are a better indicator of a company’s financial health as earnings are easier to “manage”.
RWL is comprised of the same securities as the S&P 500 index but the holdings are ranked by top-line revenue instead of market capitalization. Wal-Mart, Exxon Mobil, Chevron and Berkshire are the top holdings as of now. Consumer Discretionary, Consumer Staples. Energy and Financials occupy the top spots in terms of sector exposure.
The product made its debut in February 2008. It has returned 161.1% in compared with 141.2% for SPDR S&P 500 ETF (SPY) in last five years.
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 are worth a look, given their excellent strategies and potential to beat the market.
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