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Advisor ETF Intelligence

Why investors are flocking to smart beta ETFs

There’s a growing appetite for products like these that have the potential to outperform regular indices

By: Brenda Bouw

Date: September 18, 2017

If you’ve ever bought a product based on quality, value or momentum — or all three — you have a taste of what it’s like to purchase a smart beta exchange-traded fund.

Smart beta ETFs, formally known as strategic beta, use a rules-based investing methodology that takes into consideration one or more factors such as quality, value, and momentum — instead of traditional market-cap weighted indices.

The factors are often based on historical outperformance and are designed to improve upon the benefits of market-cap weighted ETFs. Factor diversification can also be used to complement passive index exposures.

“It’s beta with a brain,” says Ahmed Farooq, vice president of ETF business development at Franklin Templeton Investments Canada.

“You’re getting managers or dealers who goes out and revises an index of their choice and then refines it in such a way that they’re looking for better risk-adjusted returns over the long term.”

There’s a growing appetite for sophisticated investment products like these that have the potential to outperform regular indices, and come with lower fees than traditional actively managed funds

The value of Canadian ETFs reached about $130-billion as of July 31, according to Morningstar. Of those, about $15.3-billion are smart beta ETFs. That compares to an overall value of $123-billion as of March 31, of which $14.6-billion were smart beta ETFs.

Investors should look at smart beta like is an active strategy, but without the higher-cost of an active manager, says Mr. Farooq.

“You’re getting a refined way of investing, without having to pay for an active manager to make calls,” he says. “Some investors can’t stomach the potential volatility of the markets. Smart beta providers are trying to refine the way investors access the markets, not just buying and selling securities based on cap weights.”

Multifactor strategy

While some companies offer single-factor smart beta ETFs, Franklin Templeton uses a multi-factor strategy for its two smart beta funds launched in May; the Franklin LibertyQT U.S. Equity Index ETF (FLUS) and the Franklin LibertyQT International Equity Index ETF (FLDM).

The portfolios are constructed using the following factors and weights: quality – 50%, value – 30%, momentum – 10% and low volatility – 10%.

“We’re taking a higher conviction view on certain factors,” says Mr. Farooq.

A single-factor approach is considered riskier because it’s less diversified.

“We hope to provide a smoother performance by overlaying other factors on top of each other,” he says.

The FLUS is compiled using about 250 companies filtered from the Russell 1000 Index; while the FLDM is put together using the MSCI EAFE Index universe, which captures large and mid-cap representation across developed markets countries, excluding North America. (EAFE stands for Europe, Australasia and the Far East).

Mr. Farooq says the four factors — quality, value, momentum and low volatility — and their weightings, were developed by Franklin Templeton’s research team at its headquarters in San Mateo, Calif., based on historical performance data.

“We want to filter in such a way to take advantage of factors that have outperformed over the long term,” Mr. Farooq says, adding that it’s not unlike active managers who also set rules in their portfolios and rebalance on occasion. “We are trying to attain a better risk-adjusted portfolio.”

Look under the hood for quality ETFs

The advantage of a multifactor approach is that it diversifies the portfolio when one factor, such as value stocks, is underperforming.

“That means you don’t have to be active in your decisions when a certain factor is out of favour,” Mr. Farooq says.

Regardless of which type of smart beta strategy is used, Mr. Farooq recommends that investors work with their advisers to do their due diligence when looking to buy ETFs, including gaining a better understanding the new and growing choices now available in the market.

“With any smart beta strategy, it’s like buying a car; you have to look under the hood,” he says. “Do you like what you’re buying? Do you understand the methodology of what you’re trying to achieve and also, do you like the factors [the ETF providers] are choosing?”

He suggests investors use smart beta as part of an overall portfolio strategy, including as a complement to an active strategy, where appropriate.

“It’s another vehicle to get access to the market in a different way,” he says of smart beta and ETFs in general. “Think of ETFs as a mutual fund wrapper on a stock exchange. They’re providing an adviser or an individual investor with more choices.”

Advisor ETF Intelligence


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