Putting together a smart beta portfolio

Smart beta and factor investing: The basics

Most investors buy an ETF because they want a low-cost way of owning all the stocks within a particular index. Smart beta ETFs take a straightforward index but weight stocks according to characteristics such as the best-value stocks or least volatile ones.

European smart beta ETF assets quadrupled between the end of 2013 and April 2015, and the number of options for cherry picking certain elements of an index are multiplying.

"Smart beta ETFs are starting to encroach on strategies traditionally used for active managers like lowering risk or targeting higher yields and income," says Adam Laird, passive investment manager at Hargreaves Lansdown. "But they need to be used with caution. A lot of these products are very young and should be taken with a pinch of salt."

The smart beta world divides into popular minimum volatility ETFs and the more targeted world of factor-based ETFs, which focus on a bias such as value, size or quality. Chanchal Samadder, head of institutional UK ETF sales at Lyxor, says: "Minimum volatility ETFs are more core portfolio solutions while factor-based ETFs are more like building blocks to construct portfolios with. Factor strategies are quite narrow and concentrated."

These are by no means buy-and-hold solutions and bring with them the high risk of a bad bet. According to a July smart beta report by Lyxor: "There has been a substantial variation in the returns of individual factors. Individual factors have also shown quite volatile performance.Value, for example, was the best-performing factor across European equities in 2009, 2012 and 2013, but the worst-performing in 2008, 2010 and 2011."

Strategies to consider and ones to wait and watch

Minimum volatility, size and value factor strategies are the most popular with experts.By contrast, many are sceptical about momentum and quality tilts, due to doubt over the clarity of the concept and the theory behind the strategies.

Minimum volatility ETFs track indices compiled using the least volatile stocks from a parent index based on historical standard deviation data. These indices are skewed towards defensive sectors of the economy like healthcare and utilities. Value indices aim to home in on stocks which look cheap relative to fundamentals.

"I think the two obvious strategies to put together from a risk/return basis are value and minimum volatility," says David Liddell, founder of online advisory service IpsoFacto Investor.

Mr Laird says: "The two things which I think make a lot of sense are focuses on size and value. But there are a couple of things I'm sceptical about. One is momentum-based ETFs (which try to capture high-growth stocks which are likely to keep growing) because they typically have a very high portfolio turnover so can be expensive. They may perform well at times but may be very costly to achieve those returns.

"I'm also not a fan of the argument, which depends a lot on greater fool theory - that you buy something not because you believe in the price but because you think a greater fool than you will buy it down the line."Allan Miller, founder of wealth manager SCM Private says: "Momentum doesn't make any sense to me as a factor. Just because something has gone up doesn't mean it's going to keep on going up. Over the long term the strategy which stands out for me is value investing."

The other is the quality factor, which he says "sounds lovely, but no one knows exactly what it means." Providers will all use different metrics in order to define 'quality' stocks. iShares, for examples, defines that as a high return on equity, stable year-on-year earnings growth and low leverage. "I think the most nebulous factor is quality," says Mr Liddell. "I think that carries the most unclear definition."

Factors to suit European investing today

Experts agree that factor-based ETF investing should be a later consideration in portfolio construction, after you have decided on asset allocation and the weightings you want to allocate to different regions.

Some parts of your portfolio might be too small to warrant using smart beta strategies at all. But Europe could be a good region in which to experiment with smart beta. "Minimum volatility and value strategies are the kind of strategy you might want to be using in Europe," says Mr Liddell.

With volatility surging through the European market in the wake of Greek exit fears and a plummeting euro, Europe has been a tricky place to invest in and many argue there is value to be had in the region currently. Meanwhile an ETF aiming to iron out some of the biggest market swings could put some investors' minds at rest. However be aware that less volatility does not necessarily mean better returns.

Minimum volatility and value ETFs are among the smart beta areas with best choice of funds. Minimum volatility ETFs include iShares MSCI Europe Minimum Volatility (IMV) and SPDR Euro Stoxx Low Volatility (ELOW). SPDR's ETF focuses on eurozone securities and has 101 holdings, with the majority of the ETF tracking financial stocks. The iShares ETF has a large chunk in the UK, but has a more diversified base and a larger number of holdings.

SPDR Euro Stoxx Low Volatility delivered healthy returns in 2015 while closely tracking its benchmark. Returns from the ETF have differed by just 0.1 per cent from its benchmark in one month. However iShares MSCI Europe Minimum Volatility has a longer track record and is cheaper, at an ongoing charge of 0.25 per cent, compared with 0.3 per cent for the SPDR fund.

But bear in mind that in a bull market, low volatility ETFs are unlikely to deliver stellar returns, as they are likely to be concentrated in defensive stocks.

When it comes to value, Mr Laird says: "My choice for European value is the UBS ETF MSCI EMU Value (UB17). It was launched in 2009 and charges 0.25 per cent. It invests in 123 value stocks in over 11 countries - chosen by price-to-book ratio, price-to-earnings ratio and dividend yield."

He also highlights Lyxor European Quality Income (SGQG) which aims to combine more than one element of smart beta by looking at both stock quality and income. The idea behind it is that a large portion of equity returns stem from dividends and that high-quality companies tend to outperform low-quality companies. The ETF excludes financial companies, choosing instead to target a lower-risk spectrum of dividend-paying stocks from defensive sectors. It has returned positive returns over the past three years with a low level of tracking difference.

Factors to suit US investing today

As a market which active managers have famously failed to beat the US could be a good place to get exposure via smart beta passive strategies, which could add returns without piling on cost.

Experts say a focus on value, income and on size could be good biases to focus on in this region currently. Mr Laird says: "Dividends have been less of a feature in the US market than the UK typically but some of the dividend-paying companies have done very well throughout time and ETFs which focus just on income generation could be worth a look, like iShares MSCI USA Dividend IQ UCITS ETF (HDIQ)."

The ETF tracks the MSCI USA High Dividend Yield index, comprised of companies with higher than average dividend yields and track records for consistently paying them out. It was launched in June 2014 and in the year to date has lost 7.9 per cent according to Morningstar. Another ETF focused on dividends is the SPDR S&P US Dividend Aristocrats UCITS ETF (USDV), which tracks companies which have increased dividends every year for at least 20 consecutive years. The ETF is available in dollar and sterling share classes, with the sterling share class winning in 2015 in total return terms.

An alternative smart beta method of tracking income-generating US stocks is by homing in on share buybacks. A spate of major corporates issuing share buybacks this year has put US dividends back on investors' radars. Though not US-specific, the PowerShares Global Buyback Achievers UCITS ETF (BUYB), which weights stocks by net share reduction, has been highly popular. Christopher Aldous, managing director at Charles Stanley Pan Asset says: "This might be a good time to look for drivers of performance in the US which aren't just based on corporate earnings growth. Share buy backs could be a good way of doing that."

SPDR MSCI USA Small Cap Value Weighted UCITS ETF (USSC) and SPDR MSCI USA Value Weighted UCITS ETF (UVAL) are two of the few UK-listed US ETFs with value tilts. Both have lost more than 9 per cent in the past six months and were only listed earlier this year, giving them a very short track record.

Putting together a portfolio

Because they can be highly focused, combining smart-beta ETFs is a good idea. "Factor-based ETF investing makes sense for the medium to long-term, and it makes sense if you use more than one factor and combine them, but it is not a guarantee of returns," says Mr Miller. "First decide on asset allocation and then choose which regions you want exposure to. After that, decide how much to tilt to different value factors. At that point you probably don't have a large number of ETFs to choose from so look at cost and diversification."

Experts recommend not channelling more than 15-20 per cent of your portfolio into factor-based and smart beta strategies. This means for areas of your portfolio that are likely to be smaller, for example emerging markets, it might not be wise to use smart-beta ETFs.

Many smart-beta ETFs are very concentrated bets and in some cases, you are buying into a sector rather than an intelligent group of selected stocks. They can also be costly due to the high portfolio turnover and trading costs incurred by the provider, which eat into your returns.

Also be clear if markets turn, so could the fortunes of your specific factor tilt. Only play this game if you have a set idea about what kind of bias is likely to win out in current conditions and make sure to keep an eager eye on your ETF's performance.

Performance (% total return in sterling) of smart beta ETFs (in GBP)

Source: Morningstar, FE Trustnet

*1 January 2015-21 August 2015