Is This The Answer To Market Volatility?

Nick Lanyi's picture

Friday, January 29, 2016 - 12:30pm

by Nick Lanyi

Smart Beta exchange traded funds (ETFs) have been around since 2003, but they've exploded in popularity in the past year. Several major investment product providers, including Franklin Templeton, Legg Mason, John Hancock and Goldman Sachs, have all moved recently to introduce new Smart Beta ETFs.

Let's try to understand why -- and how you can use them to make big bucks in a volatile market.

First, a few terms you should know:

•    ETF: An exchange-traded fund tracks an underlying index, portfolio or commodity but trades like a security on a stock exchange. It can be bought and sold throughout the day like a stock. 

•    Beta: A statistical measure of the volatility of an individual stock (or other security, index or portfolio) versus a given benchmark, such as the S&P 500. When measuring a stock's volatility versus the S&P 500, for example, the S&P 500 has a Beta of 1.0. If the stock has a Beta of 1.5, it means that stock tends to be 50% more volatile than the S&P 500, in the same direction. If the S&P 500 goes up 10%, the stock tends to go up 15%. A stock with a Beta of 2.0 would tend to be twice as volatile as the S&P 500; a stock with a Beta of 0.5 would tend to be half as volatile. And a stock with a negative Beta would tend to move in the opposite direction as the S&P 500.

So what's a Smart Beta ETF? Basically, it's an ETF that tries to outsmart the benchmark, often using Beta.

Smart Beta ETFs re-weight the underlying index or portfolio components in an attempt to beat the benchmark outright, to beat the benchmark on a risk-reward basis, or provide investors with one or more specific characteristics. Note that a typical ETF that tracks the S&P 500 holds the 500 stocks in the index with the same weighting as the index does: by market cap. So the largest stock in the S&P 500 -- currently Apple (Nasdaq: AAPL) -- carries much more weight in the index than does the 500th largest stock, Diamond Offshore Drilling (NYSE: DO). And the Beta of such an ETF should be 1.0 or very close to it. 

By contrast, a Smart Beta approach re-weights the underlying index using a factor other than market cap. The most common types of Smart Beta ETFs use equal weighting, factor weighting (weighting portfolio components by a factor other than market cap) or a combination of screens intended to produce a particular risk-reward profile.

Equal weighting for an S&P 500 ETF means re-weighting the index so that each of the 500 stocks count equally -- so Diamond Offshore Drilling's performance would impact the index's returns as much as Apple's does. ETFs like the Guggenheim S&P 500 Equal Weight ETF (NYSE: RSP) do just that. 

Factor weighting, sometimes called "fundamental weighting," applies neither market cap nor equal weighting, but instead ranks stocks within the benchmark index by another factor, such as dividends or earnings. For example, WisdomTree Large-Cap Dividend ETF (NYSE: DLN) is made up of the largest 300 companies among all stocks, ranked by dividend. Apple, the largest stock in the S&P 500, is the 6th largest in this index; Exxon Mobil, with a 3.5% yield, gets the top weighting. The ETF has a higher yield than the S&P 500 and a Beta of 0.93, making it potentially a good choice for income-oriented investors who want exposure to the largest companies but with somewhat less volatility.

You may be asking which of these so-called Smart Beta ETFs uses Beta itself as a factor? Great question. The fact is that "Smart Beta" is an umbrella term used for ETFs that use an underlying benchmark that represents a re-weighted or brand-new index. But some ETFs do indeed use Beta itself as a weighting factor. For example, BlackRock's iShares MSCI USA Minimum Volatility ETF (NYSE: USMV) tracks an index of low-Beta large-cap U.S. stocks. It resembles the S&P 500 in sector allocation and moves in the same direction, but has a Beta of only 0.67, meaning it is two-thirds as volatile as the S&P 500.

Smart Beta ETF Popularity Is Growing
So, why are Smart Beta ETFs increasingly popular? Two reasons. One is that institutional investors -- such as the managers of pension funds -- ask for them. As with any money manager, their ultimate goal is to beat their benchmark with less volatility over time. Smart Beta vehicles, including ETFs, allow them to tweak their portfolio characteristics to get the risk-reward mix they seek. Where there's demand, supply will grow to meet it -- hence the proliferation of Smart Beta funds of all shapes and sizes.

The other reason is that individual investors have caught on, and with market volatility rising in the second half of 2015 and so far this year, folks are looking for easy ways to reduce risk without exiting the market.

Action To Take: The idea behind Smart Beta ETFs is sound, but be cautious. Don't buy any fund or ETF without understanding fully how it fits with the rest of your portfolio. In some cases, a Smart Beta ETF may be substantially similar to another fund or ETF you already own. Buying it would be redundant and complicate your record-keeping and taxes. But when a Smart Beta ETF gives you needed diversification -- say, by shifting exposure toward higher-dividend companies -- it might make sense for you.

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Nick Lanyi does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.