Wave of new strategic beta ETFs make passive investing more complicated

But it's tough to know if the ETFs' investing rules produce superior returns

Sep 13, 2016 @ 2:34 pm

By John Waggoner

No one likes more rules — unless they're rolling out a new exchange-traded fund.

At the Morningstar ETF conference last week, strategic beta was one of the biggest topics of conversation. The question now is whether they can stand up to their claims in a challenging market, and whether investors and advisers can judge their performance accurately.

Think of strategic beta funds as index funds 3.0. Original index funds simply tracked an index, such as the Standard & Poor's 500 stock index. The next generation added a single factor: Equally weighting the S&P 500 components, for example, or investing in the stocks with low price-to-earnings ratios or a record of raising dividends. One example might be the Vanguard Value ETF, which simply tracks the CRSP US Large Cap Value Index.

The newest strategic beta funds take matters a bit further by adding additional rules, typically those that replicate established techniques. Fidelity Investments, for example, recently launched a set of smart-beta funds, which it calls “factor funds.” They start trading on Thursday.

Fidelity's Dividend EFT for Rising Rates (FDRR), for example, chooses large and mid-cap dividend-paying stocks. But it adds additional rules that the company hopes will help it survive rising interest rates. For example, the companies need to have a comfortable payout ratio to ensure they can continue paying and raising dividends. They have high dividend yields and high dividend growth as well — and they have a positive correlation with rising stock prices when the 10-year Treasury note yield rises.

Similarly, the Legg Mason International Low Volatility High Dividend ETF (LVHI) looks for well-behaved, dividend-paying foreign stocks and also hedges against currency fluctuations.

All of these sound sensible, of course, but only about half the ETFs listed as strategic beta in the Morningstar database have three-year records, and the past three years have been a bull market. Relatively few multi-factor funds have even a two-year record.

“Academically speaking, a very carefully executed multi-factor strategy can produce outperformance,” says Dave Nadig, director of exchange-traded funds at FactSet Research. But there are two problems, Mr. Nadig says: The actual outperformance is small, and it takes a long time to achieve that outperformance. “The holding period can be seven years or more, and that's where some investors can get tripped up. Most are not particularly intestinally built to hold something that's losing for three years and outperforming in four years.”

The other problem is determining whether or not a fund is actually achieving what it set out to do. Sophisticated investors can run a factor analysis on the funds to see if they're getting benefits from the various factors a fund uses — momentum, dividends, value and the like.

“That's so far above what the average investor or adviser will do that it's like the difference between what the fans in the ballpark do and what Sabermetrics do,” Mr. Nadig said (Sabermetrics is the analysis of baseball statistics.) “Unless you're the Harvard endowment or a nerd like me, it's an intractable problem.”

One can't also dismiss the suspicion that multi-factor funds are a result of the rush among ETF providers to distinguish themselves from the rest of the herd. ETF advisers can simply cut stock sectors more finely — such as the the GlobalX Internet of Things Thematic ETF (SNSR) that launched Tuesday — or they can create more complex ETFs.


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