ETFs: Smart Beta tips

Smart beta or alternative index-based exchange traded funds have grown increasingly popular among the investment community. As more look to this relatively new investment strategy, there are certain steps to consider before diving in.

Victor Capital Management in a recent research note outlined seven steps that investors should take to incorporate strategic beta products effectively into an overall investment portfolio.

First off, investors should consider their desired conclusion or investment outcome with a strategic beta product. If one doesn't know why he or she is investing in an smart beta ETF, any allocation process may be doomed form the start.

Secondly, to achieve one's desired goals, an investor should fully understand how the strategy is doing what it does. Investors should look deeper into the underlying index to garner a better understanding into how the smart beta indexing methodology differs from traditional market capitalization-weighting methodology. One should consider the factor tilts or potential sector biases that make the smart beta strategy stand out from the rest.

Investors should also look to see how intuitive is the methodology at hand. Looking beyond the science behind the strategy, one should keep in mind if the smart beta strategy actually makes sense as an investment theme.

If you have a smart beta strategy in mind, an investor should also look through the history of such a methodology. While there is no guarantee of future performances, an overview of historical data will help illustrate how the smart beta methodology is expected to work in various market environments. For instance, a low volatility strategy should exhibit lower levels of volatility in periods of wide market oscillations, or a fund that focuses on the size factor should lean toward smaller companies.

Once the smart beta ETF selection process is whittled down, investors should think about how the allocation would impact their overall risk profile. A smart beta ETF should help enhance overall returns while improving diversification, lower correlation between other investment holdings and reduce risks.

Next, one should consider if the allocation negatively impacts the overall fee budge of the portfolio. If the strategy offers potential alpha, it should do so at a relatively cheaper cost to comparable active strategies that aim to also deliver similar returns.

Lastly, Victory Capital argued that investors should conduct manager due diligence to see if the people behind the strategy have experience managing products based on a rules-based indexing approach.

Victory Capital also offers its own suite of smart beta ETFs that focus on volatility-based weighting methodology to potentially help investors generate improved risk-adjusted returns. For instance, the VictoryShares US 500 Enhanced Volatility Wtd ETF (CFO), VictoryShares US EQ Income Enhanced Volatility Wtd ETF (CDC) and VictoryShares US 500 Volatility Wtd ETF (CFA) start with the broad market and screens for companies with four quarters of positive earnings. Those stocks are then weighted based on their standard deviation over the past 180 trading days. Stocks with lower volatility are given higher weightings and stocks with greater volatility are given lower weightings. Ultimately, all securities that pass the earnings criteria are present, just at different weights.

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