Strategic Beta ETFs

By Greg McFarlane AAA

As the financial markets get more sophisticated and arcane with time, the number of different types of investment schemes proliferates. It was only a few decades ago when someone first pooled together various individual stocks to create the first mutual fund, which was seen at the time as novel and perhaps unduly complicated. From there it was a logical jump to exchange-traded funds, which debuted in Canada in the late 1980s and in the United States shortly thereafter. As individual and institutional investors alike continue to look for incremental advantages, investment firms meet demand by offering vehicles that are necessarily more complex than their predecessors. Hence strategic beta ETFs, which do something beyond mindlessly tracking an underlying index. Today, strategic beta ETFs represent some of the most dynamic and potentially lucrative investments available to the ordinary investor.

First, for the unfamiliar, a quick explanation on beta (ß). It’s a measure of risk, specifically of the difference between a security’s return and that of a benchmark. For most garden-variety funds, the benchmark is the market as a whole, represented by the Standard & Poor’s 500. The argument for calculating ß is that a fund manager worth his salary ought to be able to beat a broad index comprised of nothing less prominent than the stocks of the 500 largest publicly traded companies.

ß is the movement in the security’s price, in terms of any movement in the benchmark. If the benchmark were to rise 1% while the security in question rises 2%, that’s a beta of 2. Cash and treasury bonds, whose movements have no correlation to any benchmark movements, have a beta of 0.

Strategic Beta ETF Composition

The default setting for an ETF, a non-strategic beta ETF, is to be tied to an index whose components are weighted by market capitalization. What that means is, say you have a simple index that tracks just two stocks - let’s go with Apple (NASDAQ:AAPL) and ExxonMobil (NYSE:XOM), the two largest corporations on earth, with market capitalizations of $467 billion and $413 billion respectively. Weighed by market cap, a fund that tracks that index would be invested 53% in Apple, 47% in ExxonMobil. At least until the next trading day, when the relative sizes of the components change and the numbers have to be recalculated. Of course, a typical ETF contains not two, but hundreds or thousands of components.

A strategic (or “smart”) beta ETF, on the other hand, has its components weighted by some other criteria. That could be the aforementioned measure of volatility, dividend payout, cash flow, book value, or even secondary technical metrics. Essentially, strategic beta ETFs represent something of a middle ground between active and passive portfolio management.

Large investment firms commonly categorize their strategic beta funds by particular factors: these include momentum (how quickly an issue’s price, or its volume traded, is accelerating); beta (as a metric, the one defined above, either high or low); “quality” (defined as some combination of growth and stability); and finally, buyback strength. With regard to that last one, the argument goes that the more of its stock a company buys back on the open market, the more desirable the stock becomes for the remaining investors. Subcategories of each of the preceding strategic beta ETF families are organized in a similar fashion to other ETFs, including small-, mid- and large cap; emerging and developed markets; domestic and international, etc., along with categorization by industry sector, commodity, and so on.

A general, all-purpose ETF is necessarily broader and more representative of the market than is a strategic beta ETF. For instance, here are the top 10 components of the largest ETF in existence, the SPDR S&P 500 ETF (NYSE:SPY):

Apple (Nasdaq:AAPL)

2.96%

Exxon Mobil (NYSE:XOM)

2.51%

Google (Nasdaq:GOOG)

2.07%

Microsoft (Nasdaq:MSFT)

1.75%

Johnson & Johnson (NYSE:JNJ)

1.58%

General Electric (NYSE:GE)

1.57%

Chevron (NYSE:CVX)

1.34%

Wells Fargo (NYSE:WFC)

1.34%

JP Morgan (NYSE:JPM)

1.32%

Procter & Gamble (NYSE:PG)

1.30%

Those are the 10 largest companies available for inclusion, or a close approximation thereof. Contrast that with the holdings of a strategic beta ETF, the PowerShares S&P 500 High Quality portfolio fund (NYSEArca: SPHQ):

L-3 Communications (NYSE:LLL)

1.29%

Caterpillar (NYSE:CAT)

1.28%

Walt Disney (NYSE:DIS)

1.26%

Stryker (NYSE:SYK)

1.26%

Omnicom (NYSE:OMC)

1.24%

CVS Caremark (NYSE:CVS)

1.22%

Sigma-Aldrich (Nasdaq:SIAL)

1.21%

United Technologies (NYSE:UTX)

1.21%

Hormel (NYSE:HRL)

1.20%

Baxter (NYSE:BAX)

1.19%

These companies are dwarfed by the SPDR S&P 500 ETF components, but they aren’t small caps by any stretch. Every one of them is at least a $10 billion company, although few of them are household names. L-3 Communications is an aerospace firm that makes everything from flight simulators to airport baggage scanners. Caterpillar and Walt Disney, you’re probably familiar with. Stryker makes medical devices, ranging from stretchers to artificial hips. Omnicom is one of America’s two largest advertising firms. CVS Caremark owns and operates drugstores. Sigma-Aldrich makes lab chemicals. United Technologies is one of the last true conglomerates, making air conditioning systems, rocket engines, security alarms and more. Hormel serves up Spam®, the edible kind. And Baxter manufactures vaccines and dialysis equipment.

Are there disadvantages to strategic beta ETFs? Yes, just as there are for any investment. Diversity isn’t quite as great as it is for standard market-tracking ETFs. Portfolio turnover is by necessity higher for a strategic beta ETF, and higher turnover could mean higher management fees. Sadly, the perfect investment that combines zero risk and guaranteed enormous returns continues to not exist. Strategic beta ETFs just provide a new series of advantages and disadvantages for the wise investor to assess before making a decision.

The Bottom Line

Creating a strategic beta ETFs requires more ingenuity than does assembling a standard index-matching ETF. The extra work seems to be paying off for the firms - money flowing into strategic beta ETFs almost doubled over the past year. For the investor impatient or dissatisfied with ordinary market returns, strategic beta ETFs offer a legitimate alternative. There’s almost certainly one that meets any investor’s capacity for risk tolerance, appreciation potential and more.

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