Smart Beta ETFs: What are they, and how can I use them?

The Financial Times Stock Exchange 100 (FTSE 100) Index uses a relatively simple set of rules to select companies for inclusion – it picks out the 100 largest UK companies by full market capitalisation, or the total value of the shares owned by all of a company’s shareholders, that trade on the London Stock Exchange. It then weights each company’s representation in the index by that market capitalisation.

ETFs analysis

If you want to gain exposure to the total returns (or losses) of the 100 biggest UK companies, investing in an Exchange-Traded Fund (ETF) that seeks to track the FTSE 100 Index might represent a reasonable way to go about doing so.

Rewriting the rules

What might happen if you tweaked the rules of the FTSE 100 Index? For instance, what might happen if you equally-weighted each company’s representation in the index?

Well, smaller companies would have more influence on the total return (any movements in the share price value plus any cash distributions companies have made) of the index – an ETF tracking an equally-weighted index would provide a quite different investment experience than one seeking to track an equivalent market capitalisation weighted index.

What if you simply applied a different set of rules to select a basket of stocks and construct an index? You could, for example, create a set of rules to identify securities that look inexpensive relative to fundamentals (such as the qualitative and quantitative information that contributes to the financial valuation of a company).

Such an approach would, of course, be dependent on having data available that would enable you to automatically and systematically apply these rules.

Essentially, the application of a different set of rules to construct indices describes “smart beta” – systematically applying rules to gain exposure to a particular slice of the market, namely “factors”.

What are factors?

At the heart of smart beta strategies are factors. Factors are time-tested sources of returns within and across asset classes. Institutional investors and active managers have been using factors to build portfolios for decades.

What’s exciting today is that targeted factor exposures are more widely available to a broader set of investors through smart beta ETFs.

Factors can reward investors for bearing a specific risk over a long time horizons. There are macroeconomic factors, such as strengthening economic growth and inflation, which can explain returns across asset classes. Stronger economic growth can boost share prices while rising inflation tends to drive bond prices lower, for instance.

Then there are style factors, which help explain excess returns within asset classes. In equities, for instance, value stocks (which have low prices relative to fundamentals) have historically outperformed the broader equity market in the long term.

It is important to note that an index with a factor focus is less diversified than its parent index and will be more exposed to factor related market movements. Investors should consider this style of investing as part of a broader investment strategy.

Why have factors worked and endured?

Certain factors have earned higher long-term returns as a reward for bearing increased risk, but there other dynamics that can also drive factors. Market rules or restrictions have made some types of investments off limits for certain investors, creating potential opportunities who are not subject to the same rules.

Behavioral biases can also help factors endure. Not all investors behave perfectly rationally all the time, which can create opportunity for those who can.

Why and how might you use smart beta ETFs?

Gaining exposure to factors could help you capture their potential for excess return and reduced risk, just as leading institutional investors and active fund managers have done for decades.

It is important to understand that factors potentially offer a long-term premium – and therefore short-term underperformance is likely. Factors reward bearing risks – and sometimes those risks are realised.

The construction of smart beta indices has enabled a variety of cost-effective, transparent smart beta ETFs to come to market.

Such products make factor investing more accessible, but as well as short-term underperformance, investors should think carefully about how smart beta ETFs affect their portfolios over the longer-term.

Including a value smart beta ETF in a well-balanced portfolio, for instance, will ‘tilt’ your portfolio towards value stocks – but an investor may already have a tilt towards value, even if it is somewhat unintentional.

Consider an investor who has a large exposure to emerging markets equities versus one who only invests in developed market equities; the former could have greater exposure to value stocks while the latter could have more exposure to quality (financially health firms’) stocks  – even if they did not make a conscious investment decision to gain that exposure. Single factor ETFs therefore could be considered for inclusion in portfolios by investors with a higher risk tolerance, a shorter time horizon and insights into how factors affect and interact with the rest of their investments.

Another potential way to gain exposure to factors for investors with a lower risk tolerance and shorter time horizons could be to use single ETFs that are diversified across multiple factors. As a result, when one strategy underperforms, another might pay off.

It’s important to remember that all financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed.

This article is provided by iShares as part of the What Investment educational series in partnership with London Stock Exchange.

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