Trendy quantitative exchange-traded funds, also known as smart beta, give investors exposure to algorithm-based strategies that offer lower fees and volatility than expensive, traditional stock-picking funds.
Unlike active funds, which rely on the decision-making skills of human portfolio managers, smart beta ETFs depend entirely on the numbers. The funds choose stocks and rebalance their holdings based on a mathematical or rules-based algorithm, says Marco Avellaneda, professor of mathematics at New York University and an enthusiast who has tracked exchange-traded funds since the 1990s and quant ETFs since 2002.
Though they have existed for decades, smart beta funds have mesmerized lately as the stock-picking talents of hedge and mutual fund managers hit a wall thanks to a market in full gallop. Unwilling to exit the stratospheric market just yet, investors opt for the low volatility and mathematical strategy of smart beta. But producers of the ETFs also have a goal.
[See: 7 ETFs for a Solid Portfolio Defense.]
Many investment managers are trying to give the public a variety of ETFs that mirror the Standard & Poor’s 500 or other major indexes, but that use rules-based formulas, which Avellaneda calls “a better mousetrap.” The additional features enable these funds to charge more than a traditional ETF. Hedge funds have also gotten into the game. Not wanting to miss the boat on smart beta, they have added more complex algorithms to their own ETFs and charge even more for the effort.
Investors have piled into smart beta anyway. Assets in quant ETFs soared to a record high of $592 billion globally in the first half of 2017, according to research and consultancy firm ETFGI, and are set to round out their ninth consecutive year of growth. In response to the popularity, more managers have joined the party. Of 108 total ETFs launched in the first half, 53 percent were the smart beta variety. But investors should consider the funds carefully before jumping on the bandwagon.
Will they outperform? Smart beta ETFs have a higher chance of beating their ETF peers and other management strategies in steady markets. If turmoil arises, however, it may be much harder for the computerized algorithms to predict future movements as well as they did when we had a consistent rising tide, says Peter D’Arruda, president of the International Association of Registered Financial Consultants and an investment advisor.
These rules-based ETFs also eliminate the emotion-driven choices of a human portfolio manager who may be concerned about career or business risk, says Rusty Vanneman, chief investment officer of CLS Investments. But real managers can make qualitative assessments. Instead of an algorithm buying every low price-book ratio stock, for instance, a mutual fund manager could spot value traps among them.
“Ultimately, the average value smart beta ETF can outperform the average actively managed value fund, but I do believe there are probably some really good people out there who are value investors who can outperform smart beta ETFs,” he adds.
Two of the three largest smart beta ETFs have done better in the long run. Against the S&P 500’s 8.6 percent year-to-date gain, the iShares Russell 1000 Value (ticker: IWD) returned 2 percent, the iShares Russell 1000 Growth ( IWF) 14.9 percent, and the Vanguard Value Index Fund ( VTV) 3.5 percent.
Since 2000, the iShares Russell 1000 Value led with 105.9 percent, the Vanguard Value Index Fund returned 95.5 percent and the iShares Russell Growth 54.2 percent, compared to a 75.9 percent rise in the S&P 500.
[See: 10 ETFs to Buy for Aggressive Growth.]
The long-term winner, the iShares Russell 1000 Value, chooses from the top 1,000 large- and mid-cap value stocks. The fund is highly weighted in financials, at 30.7 percent, with Berkshire Hathaway ( BRK.A, BRK.B) its top holding. The fund’s 0.20 percent expense ratio falls shy of the 1.42 percent of the average U.S. equity mutual fund and the 0.53 percent for the average ETF, according to ETF.com.
Other smart beta funds have vaulted past the market. For instance, the First Trust China AlphaDEX Fund ( FCA) has jumped 37.3 percent year-to-date, and the Credit Suisse Fl Large Cap Growth Enhance ( FLGE) also surged 32.5 percent.
What to look for. Finding the right quant fund requires some digging. Besides looking for the obvious, such as performance and a low expense ratio, investors should examine the underlying holdings, all associated costs and ease of trading, Vanneman says.
Like other ETFs, smart beta comes in a variety of packages. Firms offer a plethora of industry- and country-specific quant funds as well as traditional value and growth varieties.
Chris Huemmer, senior investment strategist at Northern Trust’s FlexShares, urges looking at how carefully the products are put together so that their algorithms do not place too much weight in one stock or sector. For instance, the mathematical formulas behind a dividend quant ETF might dictate too much exposure to telecom, utilities or consumer staples, traditionally higher dividend payers. “Our thesis is you can design just as compelling a dividend product that does not have those large overweights,” he says.
The most important thing is to read the prospectus thoroughly, Avellaneda says, adding, find out how an ETF is going to do what it says it will do. “Find out why they’re smart,” he says.
Also, investors should consider how these ETFs fit in with a broader portfolio. For D’Arruda the main question to ask: Will this strategy contribute to my goal of a happy retirement? He suggests making quant ETFs 10 percent of a “risk” portfolio, an extra account used in case costs exceed basic income backed by principal, or 5 percent for investors over the age of 70.
Start small. “The risks here are like any other risk” in that investors shouldn’t put too much of their hard-earned money into something they don’t understand, D’Arruda says. Because transparency is an issue with some quant funds, he suggests starting off slowly, perhaps by investing small, equal amounts regularly using a dollar-cost-averaging strategy.
At the same time, quant ETFs can help cushion an actively managed portfolio. “They are sold as a way to minimize risk by minimizing the human touch and instead relying on computer analysis,” he says.
[See: The Fastest Ways to Lose Money in the Stock Market.]
A fund that has a good track record over time and a clear underlying strategy may be your best bet for mitigating risk because no one can say for sure just how smart a new smart beta fund really is, Avellaneda says.
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Are Quant ETFs Worth Buying? originally appeared on usnews.com
