Smart ETFs That Multi-Task By Cutting Risk and Lifting Returns

Smart-beta exchange traded funds have evolved as the industry matures. Before, investors had ETFs with a single twist that provided a themed approach to investment styles. Now, index providers and ETF sponsors implement a multi-factor approach to potentially enhance investment returns and diminish overall volatility.

In the beginning, investors relied on market cap-weighted indices to meet their passive investment needs. However, these traditional beta indices were not designed to maximize investment risk versus returns. Some observers even argued that market cap-weighted indices may overexpose investors to outperforming stocks since the indices would overweight the same companies that have seen their market cap grow.

After a while, smart-beta “1.0” indices came along to provide superior risk-adjusted performances, but they may have shown a tilt toward unrewarded risk factors and lack of diversification.

Now, we are seeing growth in the smart-beta "2.0" index-based funds. These ETFs track multi-factor indexing methodologies that rely on multiple empirically rewarded factors and multi-weighting strategies to potentially diminish risk and enhance returns.

"It is evident that choosing good factor tilts combined with well-diversified weighting schemes generates attractive risk-adjusted performance, and that combining the different factor tilts allows for further improvement in performance, especially relative risk-adjusted performance," according to a research note entitled "Comprehensive and Well-Diversified Access to Rewarded Equity Factors: a Six-Factor Smart Beta Strategy," published in the most recent Pensions & Investments EDHEC-Risk Institute Research for Institutional Money Management supplement.

EDHEC-Risk Institute, ERI Scientific Beta researchers pointed to six factors as a useful starting point for smart-beta investments, including low risk, size, value, momentum, profitability and investment.

Low risk refers to beta or volatility, with a preference for stocks with low risk over those that exhibit wider swings. The size factor may cause a strategy to tilt toward small-caps over large-caps as a way to capture a premium in smaller companies. Value stocks looks at those with high versus low book-to-market and other valuation points. Momentum considers stocks with high versus low returns over the past 12 months, with an outlook that outperforming stocks may continue to maintain momentum and outperform. The profitability metric targets stocks with high profitability or return on equity or gross profitability. Lastly, the investment factor is defined by the allocation to various assets classes and categories.

To determine whether or not these factor are suitable considerations, the factors have to show empirical evidence of a factor premia over the long term, remain true across different regions and asset classes, and backed by sound economic rationale.

Once combined, the multiple factor may provide greater diversification benefits by lowering overall risk and potentially enhance returns as the factors diminish drawdowns in times of market distress.

Specifically, the average Sharpe ratio across the six factor tilts based on diversified multi-strategy indices is 0.56, compared to an average Sharpe ratio of 0.43 for market cap-weighted factor tilts. The Sharpe ratio is a measure for calculating risk-adjusted return, and a higher value typically reflects a more attractive risk-adjusted return.

"It appears that the combined effects of a rewarded factor exposure ensured by a dedicated proper security selection process and efficient harvesting of the associated premium through improved portfolio diversification leads to considerable Sharpe ratio improvements compared to the broad cap-weighted index," according to the research paper. "In a nutshell, an improved weighting scheme which focuses on diversification such as diversified multi-strategy weighting allows unrewarded risks to be diversified away."

A well-diversified index based on multiple factors is at the core of the so-called smart-beta 2.0 approach advocated by Scientific Beta. For instance, ETF Securities has partnered with ERI Scientific Beta on the ETFS Diversified-Factor U.S. Large Cap Index Fund (NYSE:SBUS) and ETFS Diversified-Factor Developed Europe Index Fund (NYSE:SBEU). The two ETFs’ selection process includes emphasizing investment factors, such as volatility, valuation, momentum and size.

The ETFS Diversified-Factor U.S. Large Cap Index Fund and ETFS Diversified-Factor Developed Europe Index also use a proprietary weighting strategy to provide well diversified exposure, by combining 5 models: Maximum Deconcentration, Maximum Decorrelation, Efficient Minimum Volatility, Efficient Maximum Sharpe Ratio, and Diversified Risk Weighted.

The alternative weighting methodologies have been working out so far as SBUS has gained 5.1% year-to-date, outperforming the S&P 500 3.1% increase. SBEU is down 0.6% year-to-date, but it is still outperforming the Stoxx Europe 50 Index, which is down 5.7%.

Additionally, Global X offers a line of scientific beta ETFs that are based off EDHEC-Risk Institute indices that target multiple factors, including low-volatility, momentum, size and value. The indices also combine the five models, including Maximum Deconcentration, Maximum Decorrelation, Efficient Minimum Volatility, Efficient Maximum Sharpe Ratio, and Diversified Risk Weighted.

The Global X options include the Global X Scientific Beta US ETF (NYSE:SCIU), Global X Scientific Beta Europe ETF (NYSE:SCID), Global X Scientific Beta Asia ex-Japan ETF (NYSE:SCIX) and Global X Scientific Beta Japan ETF (NYSE:SCIJ). Year-to-date, SCIU was up 4.2%, SCID was down 0.8%, SCIX rose 5.1% and SCIJ added 0.9%.

Despite their decent performances, these smart-beta ETFs have not attracted as much interest from the investment community, so potential investors should utilize limit orders to better control trades.

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