Most investor portfolios are based on a traditional model of stocks and bonds (such as a 60/40 stock-bond allocation) or some other static allocation model. The more savvy investors might even rebalance their portfolios on a regular schedule. In recent years, risk assets (such as stocks) have soared as we enter the late stages of a bull market. The question is, how can investors position equity investments for the next downturn using readily available investment vehicles without having to learn about complex derivative strategies? The answer may lie in “smart-beta” funds and strategies—and avoiding traditional safety sectors.

Smart beta combines some of the well-known advantages of passive investing with concepts of active investing by focusing on market factors, or tilts. Those tilts can lead to more exposure to value, momentum, size, or weighting methodologies. Traditional factor exposures are the French and Fama factors: momentum, size, and growth or value. Today, weighting methodologies (equal weight, price, asset) also provide investors with specific tilts, giving investors more options in choosing what their portfolio is exposed to.

A smart-beta portfolio incorporates various methodologies that may include a specific rebalancing procedure or weighting scheme. For instance, the world’s largest ETF by assets, the S&P 500 (SPY), is a market-capitalization-weighted ETF, meaning all of its holdings are weighted based on its specific size. This gives a potentially unfair weighting to the largest stocks, such as Apple, Microsoft, and Amazon. Based on current market caps, those four stocks account for 8% of the S&P 500. If these tech giants have a collectively outstanding or subpar day, it can overshadow the performance of the remaining constituents.

This issue isn’t experienced by the S&P 500 (SPY) alone, but it’s common for many of the largest ETFs, including sector ETFs such as iShares Technology (XLK) or iShares Utilities (XLU). By modifying the rebalancing, weighting, or other indexing methodologies, investors can alleviate overexposure to specific sectors or companies.

One example of a way investors can use smart beta to reduce overexposure to the largest companies in the S&P 500, still track the index, and still enjoy the benefits of broad diversification is to look into ETFs such as the PowerShares Low Volatility Portfolio (SPLV). The ETF is based on the S&P 500 and invests in 100 securities with the lowest realized volatility over the last 12 months. It also rebalances on a published quarterly schedule. According to PowerShares, the ETF has a 43% down-market capture ratio since inception. In other words, for every one dollar of loss experienced in SPY, an investor in SPLV would lose $0.43. The effect of rebalancing means that over time, the ETF will adjust itself to reflect more stable investments, further mitigating downturn losses.

Historical Benefit of Volatility Mitigation

Here’s another reason to consider smart beta. When the market turns down next, investors will want to consider the benefits of portfolios with a smart-beta tilt because no one knows what fundamental qualities will be despised by the market. Typically, when the market struggles, investors look to invest in the things everyone needs for survival. These are usually utility companies (for example, DTE Energy) or everyday personal items manufacturers (for example, Proctor and Gamble).

During the financial crisis, this theme failed to hold entirely true. Well-capitalized companies such as Proctor and Gamble did well and were rewarded by capturing only 60% of the downside when compared to the S&P 500. Their relative strength was rewarded by strong balance sheets and plenty of free cash to support its business and ongoing operations. Investors put money into businesses like Proctor and Gamble because they weren’t heavily levered like most utility companies. The fear was that companies like DTE, while critical to daily life, would be unable to support ongoing operations with paralyzed capital markets.

The following chart from Google highlights potential downsides to businesses that investors consider “safe.” Safety is relative to the past only, since we know that, historically, certain themes persist when volatility strikes. Investors know all too well that “past performance is not indicative of future results,” but constantly look back to figure out how to position the future. The past can provide a guide but should be met with healthy skepticism because what will be safe in the next crisis is yet to be seen.

Smart-Beta Google Chart

Implementation of a smart-beta strategy can be done either from the perspective of an active or passive investor and provide returns specific to different market tilts. Depending on the person, returns related to acceptable risks can be allowed by the portfolio. Mitigating risk to the largest names might be the most important consideration for one person, while reducing volatility of the overall portfolio is the goal of another. Regardless of the investor preference, smart-beta ETFs and strategies can create a portfolio as unique as the investor and provide a return profile different from that of a well-known and broad-based market-capitalization-weighted fund.

Disclosure: Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned.