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An Easy Way to Explain Smart Beta to Clients

In case you missed it, along with just about every kid finishing third grade this year, Smart Beta ETFs have now been around for about a decade. Yet despite their relative maturity, many advisors continue to find it challenging to explain Smart Beta to their clients. No matter how logical it may seem to those of us who live and breathe investing, it can sound like a complicated blur of numbers, figures, and magical formulas to an investor who is seeking a higher level of performance but knows little about market dynamics or the technical strategies behind Smart Beta ETFs.

The solution? The next time you sit down to talk about Smart Beta to a client, consider taking this simple approach we’ve used to educate third graders on the topic:

Step #1: Introduce how supply and demand affects price

Tear open a large bag of M&Ms in a third-grade classroom, and you have everyone’s attention. (The same is probably true when you sit down with a client, even though you’re just talking through the idea.) In the classroom, if we divide 125 M&Ms equally among the class so each child has 5 M&Ms, everyone is equally happy. If we ask who wants to trade their M&Ms, no hands go up. But if we introduce new information, the game changes. Tell a class of third graders that blue M&Ms are guaranteed to make them run faster, and suddenly there’s a run on the market. When the kids are asked to trade candy this time, what happens? Suddenly the balance between supply and demand has changed. Everyone wants blue M&Ms and for this reason they now have greater market value than before. What changed that value? In this case, it was the introduction of new information. And, of course, as demand increases, so does price. One blue M&M may now fetch the price of two or three M&Ms of another color.

Since the average mix of M&Ms includes only a 10% allocation to blue M&Ms, they’re already a bit scarce. If we then ask everyone who has one of the blue M&Ms to eat one, we’ve decreased the supply of blue M&M’s from 12 down to just six. Supply has now decreased significantly, demand has likely remained at least constant, and the price of blue M&Ms has thus increased yet again.

The exact same behavior is true of stocks. When demand outpaces supply, and there are more willing to buy than able to sell at a current price, price must rise.

Step #2: Introduce Relative Strength Calculation

When evaluating stocks (or any other investment asset), determining the relative strength of that stock (meaning its strength compared to other stocks) is no more complicated than our example of handing out M&Ms. It’s a basic equation that even our third graders can perform:

  • Take the current value of the stock and divide it by the value of an Index (such as the S&P 500 Equal Weight Index).
  • Multiply that number by 100 (just to get a bigger number to work with).
  • The solution gives you the “relative strength value” of the stock compared to the rest of the market.

Here’s the equation: Stock / Index X 100 = Relative Strength Value

When we handed out M&Ms to the kids, we made blue M&Ms more valuable by giving them a desirable trait (anything that makes a third grader run faster is surely a market winner!). The resulting run on the market was perhaps more emotional than it was logical. When managing stock investments, both logic and discipline become vital. Using the Relative Strength Calculation, we’re seeking to remove emotion from the process and give each stock a real, tangible value relative to the market as a whole.

Still, on its own that number doesn’t mean a whole lot. It’s just a number after all. But it’s an increasingly important number when we bring it to life by plotting its progression on a Point and Figure Relative Strength Chart.

Step #3: Introduce the Point & Figure Chart

By plotting a stock’s Relative Strength Calculation on a point & figure chart, we’re able to bring it to life and make it usable. Again, it’s an exercise even our third graders can accomplish with ease.

A Point & Figure chart offers a logical, organized method for recording price. Why is this important? Because as we saw with the M&Ms, imbalances in supply and demand drive movements in price. Once we determine which way a price is trending, so too we determine whether it is demand or supply controlling the price discovery process.

A Point & Figure chart includes columns that consist of a series of stacked Xs or Os. Xs are used to illustrate a rising price. Os illustrate a falling price. If the price of a stock is increasing (as indicated by a series of Xs), that gives us the signal to buy. If the price of the stock is decreasing (as indicated by a series of Os), it gives us the signal to sell. It doesn’t matter what the stock is, how much we’ve heard about how great a company’s products are, what analysts are predicting for its next quarter growth, or whether we’re emotionally attached to the stock. What matters is price.

When we employ that same Point & Figure charting method to record a relative strength value, we can illustrate which stocks have greater momentum than the market surrounding it at any given moment. Again, nothing matters except the stock’s relative strength—and which way it is moving—compared to the rest of the market.

Objects in motion tend to stay in motion until acted upon by an opposing force. This physical law has been shown to carry a certain financial truth to it as well. Stocks that have begun trends of outperformance versus the market, tend to continue to outperform in the future. Numerous studies over the past 20+ years have shown Relative Strength (also known as momentum) to be a robust return factor that can be used to generate market beating returns over time by systematically identifying and adopting those trends.

Step #4: Introduce Smart Beta

Our approach to building Smart Beta ETFs (or Exchange Traded Funds) is to systematically apply the signals generated by Point & Figure Relative Strength analysis unemotionally. What makes these ETFs “smart” is simply that price, the net result of all supply and demand forces within the market place, is the primary factor used to select assets in these funds. Using today’s technology, we’re able to calculate each asset’s relative strength, plot it on a Point & Figure chart, and identify any buy or sell signals. Whether we’re evaluating stocks, bonds, commodities, foreign currencies, or other assets, the market gives us everything we need to make smart choices. Trends in the market tend to last for some time and Point & Figure Relative Strength provides a process to identify those trends. The ETF structure offers a medium for enacting that information and putting it on your doorstep—in the form of a Smart Beta ETF.

By applying Smart Beta concepts in the real world, it’s much easier for clients to gain a better understanding—and much greater confidence—in this alternative investment vehicle. The best part: even your least technically-minded clients (third graders on up!) will finally be able to appreciate the making of Smart Beta ETFs.

To learn more about Smart Beta ETFs and the Dorsey Wright Relative Strength strategies, download the whitepaper Point & Figure Relative Strength Signals or contact us here. You can also listen to the Dorsey Wright weekly podcast here.

The relative strength strategy is not a guarantee. There may be times where all investments or asset classes are unfavorable and depreciate in value. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.

The information contained herein has been prepared without regard to any particular investor’s investment objectives, financial situation, and needs. Accordingly, investors should not act on any recommendation (express or implied) or information in this material without obtaining specific advice from their financial advisors and should not rely on information herein as the primary basis for their investment decisions.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.