Some smart beta strategies with low betas may not necessarily be low risk after all. In a recent conversation with Ben Johnson, director of global ETF research at Morningstar Inc., Rob Arnott, chairman of Research Associates discussed some of the issues surrounding the high valuations of some smart beta strategies. He said that some individual names that have low betas compared to the overall market are not necessarily low risk holdings.

Beta Defined

Beta is a measure of the volatility of a security or portfolio in comparison to the market. A beta of “1” would indicate that an ETF or mutual fund moves in tandem with the market, the S&P 500 as an example. A beta of 0.5 would indicate that that the security is half as volatile as the market. A beta of 1.2 would indicate that it is 20% more volatile. (For more, see: Smart Beta Funds vs. Index Funds.)

FANG Stocks

Arnott gave the example of low beta stocks that are trading at high valuations by citing the so-called FANG stocks. He indicated that of the four stocks, Facebook Inc. (FB), Amazon.com Inc. (AMZN), Netflix Inc. (NFLX) and Alphabet Inc. (GOOGL), three would be considered low beta. He cautions that putting these stocks into an investor’s portfolio would not necessarily reduce the portfolio’s risk in spite of their low beta.

Low Beta with High Valuation

Some smart beta strategies, such as low volatility, have a low beta relative to broad market benchmarks like the S&P 500. Arnott points out that a number of these ETFs have become highly valued in recent months due to their popularity with investors. (For more, see: SPLV vs. LGLV: Comparing Low-Volatility ETFs.)

The PowerShares S&P 500 Low Volatility Portfolio (SPLV) is an example:

  • Through August 26, 2016, the ETF has gained an average of 13.08% over the past three years versus 11.73% for the S&P 500 over the same period.
  • For the trailing 12 months the ETF outgained the S&P 500 18.71% versus 14.27% for the index.
  • The beta of SPLV compared to the index for three years is 0.71 and for the trailing five years is 0.56.
  • According to Morningstar, the forward looking price earnings ratio is 21.12 versus 17.41 for the S&P 500.

The results for the iShares Edge MSCI Min Vol USA ETF (USMV) are similar.

  • The ETF has gained an average of 14.12% over the past three years versus 11.73% for the S&P 500 over the same period.
  • For the trailing 12 months the ETF outgained the S&P 500 18.07% versus 14.27% for the index.
  • The beta of SPLV compared to the index for the trailing three years is 0.71.
  • According to Morningstar, the forward looking price earnings ratio is 21.12 versus 17.41 for the S&P 500. (For more, see: Smart Beta ETFs Strategies.)

Valuation Matters

“The price of anything matters; it has a bearing on how it will perform in the future. If you pick a stock, you don't say to a broker, 'I want to own that stock. Doesn't matter what the price is' or at least I hope you don't. The same applies for asset classes, is the yield spread higher or lower than historical norms? Is the P/E ratio higher or lower than historical terms? These things matter; they help to shape the long-term future returns of anything. The same thing applies to smart beta, the same thing applies to factor strategies, and right now you have the rubber band pretty stretched,” Arnott told Morningstar’s Johnson.

He went on to cite smart beta strategies such as low volatility, high quality and momentum as trading at levels higher than their normal historical valuations and that at these levels the upside for investors may be limited. (For more, see: The True Costs of a Smart Beta ETF.)

Advisor Driven

In a post on his blog earlier this year, financial advisor Josh Brown discusses what drives funds into low volatility and referenced ETFs USMV and SLPV.

“The popularity of these two ETFs is perfectly emblematic of the mood these days among financial advisors and their clients. And if you know anyone in the ETF business, they’ll tell you that the principal determiners of flows are in this order: 1) recent performance 2) whether or not advisors have been sold on them and 3) recent performance. ETFs do not sell themselves and retail do-it-yourselfers are not the drivers of AUM flows – only advisors can really move the ETF needle.”

The Bottom Line

Low volatility ETFs and other low beta investments are by their nature lower risk. However, even these investments can see their valuations run up due to an inflow of money. Financial advisors using these vehicles need to be aware of the potential ramifications on future returns. (For more, see: Smart Beta ETFs: The Pros and Cons.)

 

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