Smart-beta ETFs don’t always deliver outperformance. Sometimes, however, they do. And spectacularly, too.
In the emerging market segment, two fundamental strategies—funds that select and weight securities based on fundamentals—have delivered roughly 70% more returns than plain-vanilla, popular funds in this segment in the past year.
The PowerShares FTSE RAFI Emerging Markets Portfolio (PXH) and the Schwab Fundamental Emerging Markets Large Co. Index ETF (FNDE) are each up more than 33% in 12 months. That’s about 14 percentage points more—or roughly 70% more—in returns than the three leading emerging market cap-weighted ETFs in the same period:
Vanguard FTSE Emerging Markets ETF (VWO) is up 20%
iShares MSCI Emerging Markets ETF (EEM) is up 19%
The chart below shows that performance difference:
Chart courtesy of Stockcharts.com
In terms of an asset base, PXH and FNDE are much smaller than the vanilla giants, which together command more than $100 billion in assets. That often means these funds are less liquid relative to the big three.
In all but one case (EEM), these smart-beta funds are also more expensive, with higher expense ratios and often wider trading spreads. Liquidity and costs are important factors for every investor, but particularly for smaller retail investors dealing with smaller trades.
Still, these smart-beta funds have delivered a stellar ride in the past year.
Fundamental’s Different Tilts
PXH and FNDE both hone in on various fundamental metrics to choose and weight securities in the portfolio. In other words, these funds look at companies in terms of relative size rather than market capitalization.
PXH picks stocks based on cash flow, dividends, sales and book value—a classic RAFI fundamental approach. FNDE, too, looks at sales, cash flow and dividends/buybacks in its selection and weighting criteria.
This fundamental way of looking at emerging markets, in the end, means two key things: portfolios tend to carry a value tilt, and market price plays no role in the weighting of any given stock. By comparison, market-cap-weighted approaches are all about share price and number of shares outstanding, typically overweighting overpriced stocks and concentrating on hot sectors.
Sector Tilts Differ
The difference in approaches also translates into portfolios that diverge in sector exposures and country allocations.
For example, these five ETFs all show heavy allocation to financials, but these allocations range from 20% to 32% depending on the ETF.
The disparity in energy is even more striking. Both fundamental ETFs have about 25% of their portfolios tied to energy, while in the market-cap strategies, energy represents only about 9%. Technology, too, ranges from 8% in PXH to 25% in EEM.
Country Allocations Very Different
From a country perspective, Brazil leads PXH’s and FNDE’s portfolios, with a 30% and a 19% weighting, respectively. But VWO only allocates 9% to Brazil, and IEMG has Brazil at 7.5%. If you consider that Brazil has been one of the best-performing emerging markets in the past year, it’s easy to see why that performance would have been most felt in the smart-beta funds.
The list goes on, and you can see a detailed breakdown of each fund’s sector and country allocations in their respective ETF.com fund pages (just add the ticker at the end of the URL address, such as www.etf.com/PXH).
Smart Beta Not Always Smarter
The important thing to remember here is that when it comes to smart-beta ETFs, these funds don’t set out to outperform market-cap-weighted approaches. What they do set out to do is offer investors exposure that’s different from the market, slicing and dicing the equity universe in various ways in an effort to manage some of the inherent biases in market capitalization.
In the past 12 months, these two fundamental strategies have left the market-cap giants in the dust. But not that long ago, in 2015 for instance, both PXH’s and FNDE’s value tilt and sector/country differences underperformed IEMG, VWO and EEM.
That’s a reminder that smart-beta ETFs aren’t any smarter than market-cap weighting. They are merely alternatives to market cap that sometimes translate into outsized gains, and sometimes into outsized losses.
Contact Cinthia Murphy at email@example.com