Questions to Ask Your “Smart Beta” ETF

One of the most common complaints we hear from investment advisors attempting to evaluate “smart beta” ETFs is that the category itself lacks cohesion. ETFs employing a variety of different strategies, with a wide range of risks and objectives, have been given the “smart beta” label simply because they do not track traditional market-cap weighted benchmark indices.

We share in this concern. Rather than attempting to treat “smart beta” ETFs as a category, we believe investment advisors are better off judging ETFs on the basis of their own underlying strategies. As a starting point in this process, the following presents a few questions we believe advisors should ask when evaluating these strategies.

What is the objective of the underlying strategy?

In order to judge how successful a strategy might be, we believe it’s important to first identify what it’s trying to accomplish. So-called “smart beta” ETFs have a wide range of objectives, such as maximizing dividend income, increasing or decreasing market risk, improving risk-adjusted returns, or seeking increased exposure to other specific characteristics. Each strategy should be judged based on how well it achieves its own objective, and compared to other strategies with similar objectives.

From what universe of stocks are potential holdings selected?

While many ETFs hold every security in their underlying indexes, others track strategies that are more selective. For the latter group, it’s important to examine a strategy’s universe of potential holdings in order to determine how a portfolio might evolve over time. On the one hand, a universe that is too broad may produce biases that are unexpected or undesirable. On the other hand, a universe that is too narrow may limit the level of exposure to certain characteristics sought by a strategy. Advisors should pay attention to how well a strategy under consideration achieves this balance.

How are stocks selected?

For a strategy that doesn’t own every security in its underlying universe, it’s crucial to understand how portfolio holdings are selected. While some strategies select holdings based on single factors, others combine multiple factors. The more complex a strategy is, the more important it is to understand the rationale for combining multiple factors. While the results of a strategy may seem compelling, advisors should consider the economic or behavioral basis for a strategy potentially producing similar results in the future.

How are weighting assigned?

While the first generation of ETFs tended to track indices that assigned weightings based on relative market capitalization (i.e. the size of a company), a variety of weighting methodologies are now applied to ETFs. Examples include equal-weighting, weightings based on certain fundamental characteristics, such as earnings or dividends, weightings based on factors, such as momentum or value, as well as weightings based on more sophisticated models. In each case, a strategy’s weighting methodology may serve to emphasize or de-emphasize certain portfolio characteristics.

How often is the strategy reapplied and the portfolio rebalanced?

While traditional market-cap weighted benchmark indices tend to produce relatively low portfolio turnover, many other strategies tracked by ETFs require more frequent rebalancing and higher levels of turnover. For example, the weightings within an equally-weighted ETF will become uneven over time, due to the divergent performance of its underlying holdings. As a result, an equally-weighted ETF must periodically reduce exposure to its holdings that have recently performed best and increase exposure to its holdings that have recently performed worst. Similarly, more complex strategies tracked by ETFs must be reapplied periodically in light of recent performance and changes in company fundamentals. Seeking to balance the costs and benefits of this process, many strategies are reapplied and rebalanced on a quarterly, semi-annual, or annual basis.

Fortunately, despite the higher level of portfolio turnover found in ETFs tracking non-market cap weighted indexes, most have been able to execute their underlying strategies without compromising their tax efficiency. For example, less than 5% (9 of 186) of the US equity ETFs categorized as “strategic beta” by Morningstar had capital gains distributions in 2014, compared to 8.9% (8 of 90) of the index-based US equity ETFs not categorized as strategic beta.

Of course, the questions listed above are meant only to be a starting point for those attempting to get their arms around a continually expanding and evolving universe of so called “smart beta” ETFs. Beyond these questions are many others pertaining to how well the risks and objectives of different ETFs align with those of individual investors. For these questions, we believe investment advisors should play an essential role, evaluating the function that each ETF provides in the context of a diversified investment portfolio, and overall financial plan.

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