Newfangled exchange-traded funds lumped into the catchall smart beta/thematic/factor-based category aren’t so newfangled anymore. They’ve been around the block and now represent 34% of the total number of roughly 2,130 U.S.-listed equity ETFs, according to investment research firm CFRA.
But it’s a variegated category whose underlying indexes are constructed in different ways, and that can affect the investor experience.
“The type of index construction, and therefore the type of ETF construction, can significantly impact the exposure and the returns and the sector concentration that an investor gets exposure to,” said Aniket Ullal, vice president of ETF data and analytics at CFRA. He spoke yesterday during a presentation as part of the Money Show’s ETF Investing Virtual Expo.
Ullal defined the smart beta category as index- and rules-based, alternatively weighted thematic and factor ETFs. Traditional beta ETFs, on the other hand, are index-based, market capitalization-weighted, broad-market ETFs. He noted that while smart beta funds are the largest category by fund numbers, traditional beta funds still make up 80% of the more than $5.3 trillion in assets among U.S.-listed equity ETFs.
He highlighted the nuances of smart beta ETFs by digging into how certain factor-based funds are constructed. “Factors” are the attributes of an asset that both explain and produce its excess returns. These can include quantitative factors such as an asset’s ability to throw off dividends or its low volatility (an equity can also have multiple factors).
The low-volatility category, Ullal said, implies that investors are getting exposure to stocks with lower volatility than the broader market. He added that there are two types of low-volatility ETFs. The first type provides pure-play exposure to low-volatility stocks regardless of sector concentration. One example is the Invesco S&P 500 Low Volatility ETF (SPLV), a roughly $13 billion fund consisting of the 100 securities from the S&P 500 with the lowest volatility during the past 12 months.
The other way to construct a low-volatility ETF is to create a so-called optimized basket. That entails selecting low-volatility stocks within a parent index while ensuring that the sector balance and overall performance doesn’t deviate too much from that of the parent’s set of securities. An example is the iShares MSCI USA Min Vol Factor ETF (USMV), a $29 billion fund.
“With SPLV, more than 20% of its exposure is in utilities, which is very different from the S&P 500,” Ullal explained. “Meanwhile, the USMV’s overall exposure, while still tilted toward low-volatility stocks, is more similar to what one would expect to see in the S&P 500 or an MSCI-type index where information technology, consumer staples and healthcare are the largest sectors.”
Has that translated into performance differences? Yes, but it depends on the time frame. In the short term, the more pure play low-vol SPLV fund is down 3.7% year to date through yesterday, but it’s up 3.6% during the past year. The USMV fund is down 7.6% year to date and down 3.2% during the past year. Yet over the three-, five- and 10-year periods, both funds have similar returns. If anything, the “optimized” USMV fund has topped the SPLV fund by about 40 basis points on an annualized basis during both the five- and 10-year periods.
“It’s important to understand that factor ETFs go through cycles, and that can be an important part of portfolio construction,” Ullal said. “The choice of time period can influence the performance of factor ETFs.”