Smart-Beta Sector ETFs to Navigate Current Markets

Markets ETF Trends

After a multi-year rally, the equities market is trading at elevated valuations. Consequently, investors seeking exposure to stocks may want to consider a smart-beta, multi-factor exchange traded strategy to limit risks and potentially enhance returns.

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“High Valuations and limited multiple expansion may hinder broad market returns,” Steve Deroian, Head of ETF Strategy at John Hancock Investments, said on the recent webcast, A Smart (Beta) Approach to Sector ETFs, predicting minimal price-to-earnings multiple expansion this year.

Nevertheless, Deroian pointed to certain sectors that may offer growth opportunities at a reasonable price. For instance, looking at the PEG ratios of the S&P 500 sectors – the price/earnings-to-growth ratio, the strategist calculated that the financials, healthcare, technology and consumer discretionary sectors appear undervalued, whereas telecommunications, utilities and consumer staples are trading at more pricier valuations. John Hancock has a more neutral view on industrials and materials.

Many would turn to market-cap weighted or actively managed sector strategies to gain targeted exposure to these market segments. However, Deroian warned of the potential shortfalls, such as high concentration in individual securities in market-cap weighted funds or the high turnover and trading costs in active funds.

In a survey of financial advisors on the webcast, 35% of respondents pointed to reducing volatility as their main motivation for smart-beta investments, followed by 31% who want higher returns and 27% who want to diversify away from market capitalization.

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Alternatively, investors may look to a smart-beta, factor-based index ETF strategy for broad diversification. For instance, Joel Schneider, Senior Portfolio Manager & Vice President of Dimensional Fund Advisors, pointed to four factors backed by academic research that have historically shown higher expected returns over time, including the equity premium, small-cap premium, value premium and profitability premium.

Specifically, the market equity premium reflects the outperformance of stocks over bonds. The small-cap premium corresponds to the outperformance of small-caps over large-caps. The value premium relates to value stocks over growth stocks. Lastly, the profitability premium shows that highly profitable companies tend to do better than less profitable companies. On the webcast survey, the majority of advisors pointed to relative price or valuations over growth as the most attractive factor in the current environment.

Schneider pointed out that a study conducted by University of Chicago Professor Eugene Fama and Dartmouth College Professor Kenneth French found that focusing on smaller stocks and those with lower relative prices may improve a portfolio’s expected return. Additionally, in a separate research paper, University of Rochester Professor Robert Novy-Marx identified profitability as another factor that enhances expected returns.

SEE MORE: Smart Beta ETFs: Weighing Single- and Multi-Factor Methodologies

When combined, the various factors may help improve a portfolios risk-adjusted returns over time. Schneider explained that the Dimensional Fund Advisors’ multi-factor strategies selects securities of a specific sector with a desired market capitalization range, with an increase emphasis on higher expected return securities. The securities will exhibit lower relative price, higher profitability and lower market capitalization. Moreover, securities’ weights are capped to diminish concentration.

John Hancock has come out with a number of smart beta ETF options that track indices developed by Dimensional Fund Advisors, including the John Hancock Multifactor Consumer Discretionary ETF (NYSEArca: JHMC), John Hancock Multifactor Financials ETF (NYSEArca: JHMF), John Hancock Multifactor Healthcare ETF (NYSEArca: JHMH), John Hancock Multifactor Technology ETF (NYSEArca: JHMT), John Hancock Multifactor Consumer Staples ETF (NYSEArca: JHMS), John Hancock Multifactor Energy ETF (NYSEArca: JHME), John Hancock Multifactor Industrials ETF (NYSEArca: JHMI), John Hancock Multifactor Materials ETF (NYSEArca: JHMA) and John Hancock Multifactor Utilities ETF (NYSEArca: JHMU).

In a survey on the webcast, among the majority of those advisors who have not invested in smart-beta strategies, many pointed to their lack of understanding to a smart-beta strategy as the main impediment to investments, which suggests that the industry still needs to promote investor education before more will utilize these smart beta ETFs.

Financial advisors who are interested in learning more about factor-based smart-beta sector investments can watch the webcast here on demand.

This article was provided by our partners at ETFTrends.