Traditionally, asset allocation has involved the use of different asset classes such as stocks, bonds and cash in various proportions to gain the risk-reward balance that financial advisors wanted to achieve for their clients. Sub asset classes such as large-cap, mid-cap, small-cap and international stocks are also common.
The financial crisis of 2008-09 saw many asset classes that traditionally had a low correlation to each other moving in lockstep to the downside. There were few safe havens for investors during this time period. Coming out of the financial crisis, financial advisors and mutual fund and exchange-traded fund (ETF) providers looked for additional ways to diversify. One outgrowth of this search has been the emergence of smart beta factor investing. (For more, see: What Advisors Need to Know About Smart Beta ETFs.)
This method attempts to identify a factor or attribute within an overall investing strategy that will yield outperformance. For example, carving out the low volatility slice of a traditional market-cap weighted index like the S&P 500 represents a factor. Factor investing has been around for a while. Growth and value are factors. Dividend growth is also a factor.
While there are a number of factors used in smart beta ETFs, among the most popular are:
- Value: This might include a sliver of an index like the cheapest stocks in the S&P 500 Index represented by the Guggenheim S&P 500 Pure Value ETF (RPV).
- Size: The iShares USA Size Factor ETF (SIZE), for example, tracks a group of domestic large and mid-cap stocks with small relative market capitalization.
- Momentum: This can include stocks with pure momentum or relative momentum, such as the iShares MSCI USA Momentum Factor Index ETF (MTUM).
- Low volatility: The PowerShares S&P 500 Low Volatility ETF (SPLV) targets the 100 stocks from the S&P 500 with the lowest volatility over the past 12 months.
- High quality strategies: These often involve dividend stocks. The Schwab U.S. Dividend Equity ETF (SCHD) is an example.
Low volatility ETFs in particular have been enjoying solid returns over the past year and have been attracting waves of new investment dollars. (For more, see: Are Smart Beta ETFs Active, Passive or Both?)
New Type of Diversification
While traditional asset allocation reduces risk by using different asset classes, diversifying among factors entails identifying and targeting specific risk factors. Individual investors and financial advisors may find that factors provide an additional tool in their efforts to diversify.
Factor-based ETFs are usually developed in “the lab” based on back testing. This means that the ETF provider will look at different attributes like risk among portions of established indexes like the S&P 500 or the Russell 2000. They will test the performance and risk of an ETF based on this factor using past market results and the rules that will govern the ETF if launched.
Their performance under actual market conditions can vary from a back test for any number of reasons including a large influx of assets into the strategy. This can cause capacity constraints in implementing the rules on which the strategy is based. (For more, see: Smart Beta ETFs: The Pros and Cons.)
Another issue that large inflows can cause is high valuations. This is now occurring with low volatility smart beta ETFs. There is an ongoing debate between industry heavyweights Rob Arnott of Research Associates and Clifford Asness of AQR Capital Management LLC over the impact of valuation on factors. Arnott feels that high valuations increase the risk of poor performance for factors such as low volatility. Asness disagrees.
Don’t Abandon Traditional Allocation
Certainly financial advisors can make their own decisions as to what is best for their clients, but I suspect that going “all-in” with smart beta factor-based ETFs is not a good strategy for most clients. Asset classes such as bonds, cash and perhaps certain types of alternatives can provide diversification and risk control. Smart beta strategies are mostly stock-based and too much of an allocation there is still risky. (For more, see: How to Evaluate Smart Beta ETF Strategies.)
The value might be in using a smart beta factors as part of a “core and explore” strategy where factor-based ETFs are used in addition to more traditional holdings such as core market-weight index funds. Additionally, factor-based strategies can be used to complement each other. A combination of factors such as momentum and high quality might provide a level of diversification that can improve risk-adjusted performance over time.
This desire to diversify among various factor-based ETFs has given rise to multi-factor ETFs in which the manager attempts to provide the diversification for you. Multi-factor ETFs are not all created equal. It is important that investors and financial advisors understand the manager’s strategy and the factors to be employed before investing.
The Bottom Line
Diversification is an important investing strategy. Smart beta ETFs based on factors can be a tool for financial advisors and individual investors to use in achieving portfolio diversification. And while factor-based smart beta ETFs can provide an additional level of diversification among the stock portion of a portfolio, it is important that advisors understand how the performance of a given factor correlates with the rest of the client’s portfolio. (For more, see: How to Explain Smart Beta Strategies to Clients.)