05/11/16   Smart Beta Update

Editor’s Corner

Ron Rowland

The ETF world is expanding at an incredible pace, with the quantity of funds more than doubling since the end of 2009. Asset growth is on an even steeper trajectory. At the end of April, 1,884 ETFs and ETNs holding $2.2 trillion in assets were available to U.S. investors. Within this industry is perhaps an even faster-growing segment—the world of smart-beta ETFs.

Some firms prefer calling this relatively new breed of ETFs “alternative beta” instead of “smart beta,” but you shouldn’t get hung up on the label. Smart beta is often defined as an investment methodology that uses a security-weighting scheme other than market capitalization. Historically, “beta” was a measure of systematic risk of a fund or portfolio, expressed as a ratio to the market as a whole. Since the “market as a whole” is capitalization weighted, the beta part of smart beta isn’t necessarily beta, and the results of these approaches are not always better or smarter. Like I said, don’t get hung up on the name—it is just what the industry has settled on.

The quantity of smart-beta ETFs has more than tripled in recent years, jumping from fewer than 190 at the end of 2009 to more than 600. If you’ve been paying attention to new ETF releases, then you’ve also seen a proliferation of terms like single factor, multi-factor, theme-based, equal weighted, volatility weighted, and a host of other alternative words. All of these imply a product that is not using traditional capitalization weighting.

Each week, I build the Edge Charts included with this article from traditional capitalization-weighted ETFs. They represent what the market is doing within each of the predefined categories. It is also possible to build similar charts from smart-beta ETFs, and I have shared those in this space a few times over the past year.

Today, a ranking of ETFs that isolate single market factors would show that Low Volatility is the most important factor among the best-performing funds. Before you rush out and shift all of your investments to low-volatility funds, remember that factors rotate. Just like the sector, style, and global rankings change over time, so do factor rankings. In the current environment, the best-performing factors after Low Volatility include Current Yield, Quality, Momentum, Dividend Growth, and Value. Market Capitalization, the traditional weighting scheme, is also a factor, and it currently resides near the middle of the rankings with a momentum score of 13—the same as the Large-Cap Blend style category.

Surprisingly, the next factor in the rankings is Small Size, which is often considered the opposite of Market Capitalization. However, these two have nearly identical rankings, which indicates the market is paying much more attention to other factors and capitalization is taking a back seat. Continuing down the rankings, we have Growth, Earnings, Revenue, and finally High Beta in last place. Many of the new smart-beta ETFs follow a multi-factor strategy, and the possible combinations are endless. However, based on the single factor rankings, it would be easy to surmise that a Low Volatility High Yield fund should be performing quite well.

Strategy-based ETFs typically track a smart-beta index, providing a means to evaluate them in a similar fashion. The current rankings of strategy ETFs show that Defensive is currently the highest-ranked strategy, followed by Equal Weighting, Buy & Hold (capitalization weighted), Sector Rotation, and Covered Calls. Lagging strategies include Market Neutral, Hedge Fund Replication, Volatility Hedged, 13F Filings, and Long/Short. Two strategies are currently in the red, and they are Currency Hedging and Short Selling. I place event-driven ETFs in their own grouping. Today, Spin-Offs, IPOs, Insiders, and Stock Splits are producing above-average performance. The laggards in this group are Buybacks, Float Shrink, Mergers, and Earnings Surprises.

Most of the visible innovation is taking place in the ETF space because it is relatively inexpensive for fund sponsors to test a new idea in the live marketplace. However, this ease of bringing products to market also means some bad ideas have been introduced. Additionally, the sheer quantity of new arrivals means that volume and liquidity is low for many of these new funds. While this article has focused on ETFs, there are also mutual funds that contain many of these same strategies and combinations—the world of smart beta is not limited to ETFs.

Investor Heat Map 5/11/16

Sectors

Real Estate surged to the top of the rankings. It posted the largest gain among our 33 equity categories this past week on its way to a five-position climb to the top. Real Estate was providing the leadership when the calendar rolled over to 2016, and now 17 weeks later it has regained that position. Only three sectors posted momentum improvements for the week, and it was Utilities and Consumer Staples that accompanied Real Estate in this accomplishment. Utilities climbed a spot to fourth, and Consumer Staples jumped four places higher to fifth. The defensive nature of these gainers calls our declaration of a shift from defensive to smokestack mode a few weeks ago into question. The rough week pushed Energy and Materials each a spot lower, but both bounced backed strongly in yesterday’s market action. Telecom and Industrials also lost relative strength, with both slipping from the upper to lower half. Financials improved a spot, Consumer Discretionary fell one, and both are still among the below-average performers. The bottom two spots remain occupied by Health Care and Technology, with Technology the only sector sporting a negative momentum score.

Styles

Only a single style category gained momentum over the past week, and that honor goes to Large-Cap Growth. Mega-Cap came close by holding steady, but the other nine all posted reductions. Mid-Cap Value continues in the leadership role that it has held for nine of the past 10 weeks. Small-Cap Value added another second-place notch to its belt. Last week, Large-Cap Value climbed two spots to third, giving the Value trio complete control of the top. This week, Mid-Cap Blend moved a spot higher and pushed Large-Cap Value down a notch. All of the ranking changes in the lower half resulted in larger capitalization categories gaining against smaller ones. Large-Cap Blend moved up two, Mid-Cap Growth improved one spot, and both Mega-Cap and Large-Cap Growth climbed two places. The move by Large-Cap Growth pulled it out of the last-place slot it had occupied for the past three weeks. Micro-Cap plunged from fifth to 10th, but it is Small-Cap Growth now sitting on the bottom.

Global

Latin America saw some selling pressure this past week and lost momentum, but it extended its solid grip on the first-place ranking to 10 weeks. Canada is again in second place, although the commanding lead that it and Latin America held over the rest of the pack has now diminished. Last week, we lamented about how the U.S. was stuck in the lower half. This week, it jumped four places higher to land in third and push Pacific ex-Japan down to fourth. World Equity improved a position, and a small momentum increase for Japan was enough to boost it four places higher. The U.K. plunged five places lower and is now in danger of losing its positive trend. Emerging Markets fell even further, which makes it and China the only two global categories in the red. China fell deeper into its negative trend.

 

Note:

The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

 


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Benjamin Franklin


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