In the U.S., the bulk of cap-weighted, plain vanilla, equity-based exchange traded funds (ETFs) are dedicated to domestic stocks. Knowing that, it is not surprising that the same sentiment applies to smart beta ETFs. However, international stocks, both developed and emerging markets, are ripe with potential for smart beta strategies.
Actually, some advisors and investors that are new to evaluating alternatively-weighted ETFs may not know that some of the oldest smart beta ETFs trading in the U.S. are international equity funds. In most cases, the oldest international smart beta ETFs are dividend funds, but more sophisticated and unique strategies for ex-U.S. equity investments have been coming to market in recent years.
International smart beta ETFs can present investors with compelling alternatives to traditional beta funds tracking well-known benchmarks, such as the MSCI EAFE Index or the MSCI Emerging Markets Index.
For example, the JPMorgan Diversified Return International Equity ETF (JPIN) uses a multi-factor approach to ex-U.S. developed markets. Conversely, the MSCI EAFE Index is cap-weighted, a methodology that can expose investors to sector risk and overvalued stocks. JPIN “screens stocks based on factors — including value, size, momentum and low volatility — that have historically driven strong performance. When these factors are combined, risk and return outcomes can be improved,” according to JPMorgan Asset Management.
Emerging Markets, Too
Emerging markets are fertile ground for fundamentally-weighted strategies, as well. That makes sense when considering some of the most frequent criticisms of cap-weighted emerging markets indexes. Those criticisms include too much exposure to a small number of sectors and excessive weights to a small number of sectors.
Just look at the MSCI Emerging Markets Index. Global investors benchmark over $1.9 trillion to this index, but those bets are highly concentrated at the country level. The MSCI index allocates over 47% of its weight to just three countries – China, India and Brazil. Sector risk exists as well for similar reasons of concentration.
Said differently, a supposedly diversified index presents investors with the potential for significant geographic and sector-level risk.
Smart beta strategies can ameliorate those issues. Take a look at the JPMorgan Diversified Return Emerging Markets Equity ETF (JPEM). JPEM does not track an MSCI index, so it excludes South Korea and the ETF's weight to China is well below that of the MSCI benchmark. JPEM's exposure to ASEAN and EMEA nations is robust compared to traditional emerging markets funds
JPEM's “index uses a multi-factor stock screening process that has historically driven strong performance,” according to the issuer.
Pros And Cons
As was highlighted above, some international smart beta strategies can mitigate geographic and sector risk. Other funds in this category can produce robust income by focusing on dividends while others can limit volatility and find value stocks by using a multi-factor approach.
However, there are some drawbacks to be aware of. Namely, there are times when the largest ex-U.S. markets and companies will drive the relevant indexes higher. A real-time example is the MSCI Emerging Markets Index in 2017. Previously under-performing large- and mega-cap emerging markets companies are rallying this year, lifting cap-weighted benchmarks along the way.