Advisers are finding it increasingly difficult to cut through the clutter of an ever-growing universe of ETFs. In particular, these choices are clouded by an emerging genre of non-traditional ETFs, many of which were created for the purpose of attempting to deliver “better beta” or alpha and are branded as being “fundamentally based.” With more of these non-beta ETFs expected to hit the market, advisers likely will need help identifying and differentiating the host of options.
Having so many choices is a good problem to have, but it is important to understand the differences among them to construct an investment portfolio that suits its intended purpose. It may be helpful to put all ETFs into two broad categories: beta and alpha.
ETFs designed to seek market risk and return fall under the beta umbrella. They typically track “market” indexes in which all the stocks in a relevant market are included and they are weighted based on market capitalization. The ETF market has long served advisers looking to simply replicate the returns of the market and delivering beta was preferred. Because of the additional benefits provided by ETFs such as tax efficiency, exchange-traded liquidity and transparency, the ETF industry has evolved to include alpha-pursuing funds for investors and their advisers who are looking to achieve better investment results. These funds don't own all of the stocks in a respective market and often use alternative methods to weight them rather than market capitalization.
These two broad categories, beta and alpha, could be further grouped as traditional or non-traditional.
Beta and alpha are statistical measurements used to evaluate the risk-reward profile of an investment. The four investment strategies we listed in the table are all subject to market risk — that is the risk that the underlying securities will lose value. Each approach presents some unique risk-reward characteristics. Traditional beta strategies mitigate a degree of individual security risk through diversification but, because they are market capitalization-weighted, the largest companies in the index can represent a significant weighting and create unwanted risk. The non-traditional beta and alpha approaches attempt to limit exposure to the largest stocks and increase exposure to others in an attempt to provide better returns. There are times, however, when alternative weighting approaches and stock level factors, such as valuation, become less meaningful and their effectiveness may diminish.
The area of the ETF market where we have found causes the most confusion is between the nontraditional beta and nontraditional alpha.
Nontraditional beta generally tries to provide slightly different, but better returns than the market. In other words, an alternative passive strategy. These ETFs typically track indexes that vary slightly from cap-weighted indexes. In most cases, they own the same stocks as the index but the constituents are either equal-weighted or use alternative measures of size to weight. Many of these ETFs are marketed as tracking “fundamental” indexes because the constituents are weighted based on total book value, total sales, total dividends or other factors.
It begs the question: What are fundamentals? Do book value, total sales and total dividends really provide informational value of the future stock price of a company? Or is it just another way of measuring how big the company is? After all, the largest U.S. companies tend to have greater book value, sales and dividends. We don't believe these measures are “fundamental” factors.
The other subcategory of the ETF market that focuses on nontraditional alpha seems to be getting a majority of the attention among advisers looking for more than better beta. These ETFs typically track indexes designed to seek risk-adjusted excess returns. Because stock prices are subject to market factors that can make them deviate from a company's “true” value, these indexes use fundamental evaluation measures to select and weight constituents commonly used by professional money managers such as price-to-book, return on assets, price momentum, sales growth, etc.
These indexes mimic the approach and behavior of active managers in many ways by applying certain rules relating to when to buy and when to sell. Also governed by the rules are what universe of stocks to select from while attempting to limit exposure to over-priced stocks and increase exposure to those which are trading at more-attractive valuations.
Academic literature supports the possibility of generating outperformance through the use of fundamental measures. To illustrate this point, we started with a large universe of stocks and divided them into deciles based on their ranking on a single valuation factor — price to cash flow. The following chart shows the average annual performance of the stocks in each decile held for one year with the process repeated each year. Although past performance is no guarantee of future results, this example shows that stocks with a better price-to-cash-flow valuation historically outperformed those with a worse price-to-cash-flow valuation. The fact is, fundamental valuation matters.
While many single valuation factors can be useful in stock selection, we believe multifactor models are a more prudent approach and generally more consistent over time. The stability of a quantitative selection model over time is an important consideration when choosing the proper mix of valuation factors.
Cutting through the clutter of new ETFs and in particular, those in the better/alternative beta versus the fundamentally based alpha ETFs, may still be a challenge for many investors and advisers. But putting them into one of the four subgroups can go a long way toward finding the right ETF to help clients reach their financial goals.
Dan Waldron is senior vice president and ETF strategist at First Trust Portfolios LP.