ETF companies have been rushing to introduce portfolios that weight holdings in unconventional ways. Popular choices give each stock an equal weighting or emphasize holdings with characteristics such as low volatility. The strategy, ‘smart beta,’ has become one of the hottest investment trends in the industry.
But the design of these funds are active, in that they’re betting against the market-cap weighted approach, said Ben Johnson, director of global ETF research at Morningstar, during ETF Trends’ Virtual Summit.
“Like active managers, you’re going to see performance cycles, and your ability to reap any gains to be had from taking this active bet are directly related to your ability to sit there, stick with it through thick and thin,” Johnson said.
Because of that, smart beta is appropriate for investors who can stomach volatility and hold for long periods of time, not for market timers, Johnson and other ETF pundits said.
“If you can hold a quality ETF for 10 or 20 years, do I think there are things in the market that could lead to risk adjusted outperformance? I do,” said Matt Hougan, CEO of ETF.com. “I’m just not a good enough investor to realize that.
“I don’t use the products myself because I am a wimpy investor. If I went through a period where a smart beta fund underperformed, I would panic and sell.”
But Hougan believes it can be a great strategy for the right person.
“All advisors know there are clients who will not be satisfied with my market-cap weighted portfolio,” Hougan said. “They want to have something they think is smarter, that’s going to beat the market. If they’re going into a 9 basis point smart beta fund instead of a 1 percent active fund, the world is a better place.”
But now there are multi-factor funds that combine factors, Johnson said. These funds can make the drawdowns shallower, but may not make as much on the upside.
“The multi-factor funds, if nothing else, stand a better chance of good outcomes for investors to the extend that they’ll tamp those cycles,” Johnson said.