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Smart-Beta ETFs: Not All Factors Are Created Equal

editor@etftrends.com (ETF Trends)

More exchange traded fund investors are looking to smart beta or alternative index-based strategies to fill out their investments, and focusing on which targeted factors within the indexing methodology matters when appropriately balancing a portfolio.

On a recent webcast, Smart Beta Factors: How Many and What is Ideal? , Joel Schneider, Senior Portfolio Manager and Vice President of Dimensional Fund Advisors, explained that investors should focus on four factors backed by academic research that have historically driven expected returns, including market equity premium, small-cap premium, value premium and profitability premium.

Related: ETFs Are a Hit Among Financial Advisors

“Academic research has shown that stocks characterized by smaller capitalizations, lower valuations, and higher profitability have delivered higher expected returns over time,” Schneider said.

Specifically, Schneider pointed out that a study conducted by University of Chicago Professor Eugene Fama and Dartmouth College Professor Kenneth French found that focusing on smaller stocks and those with lower relative prices may improve a portfolio’s expected return. Additionally, in a separate research, University of Rochester Professor Robert Novy-Marx identified profitability as another factor that enhances expected returns.

In a survey of advisors participating the webcast, 36% of respondents feel stocks will continue to exhibit a premium over bonds, 31% favor relative price or value over growth style, 27% target profitability and only 6% see a small-cap premium.

While there are many various active styles and factor-based strategies available, these four factors have been persistent across time periods, are pervasive across markets, show long historical data points and can be implemented in a cost-effective manner.

“Not all factor-based strategies are created equal,” Schneider said.

Phil Fontana, Head of Product Development at John Hancock Investments, explained that in an attempt to capitalize off these factors, John Hancock has launched a suite of smart-beta ETFs that track indices developed by Dimensional Fund Advisors, including the John Hancock Multifactor Large Cap ETF (JHML) and John Hancock Multifactor Mid Cap ETF (JHMM) , along with sector-specific John Hancock Multifactor Consumer Discretionary ETF (JHMC) , John Hancock Multifactor Financials ETF (JHMF) , John Hancock Multifactor Healthcare ETF (JHMH) , John Hancock Multifactor Technology ETF (JHMT) , John Hancock Multifactor Consumer Staples ETF (JHMS) , John Hancock Multifactor Energy ETF (JHME) , John Hancock Multifactor Industrials ETF (JHMI) , John Hancock Multifactor Materials ETF (JHMA) and John Hancock Multifactor Utilities ETF (JHMU) .

The smart-beta ETFs’ underlying indices select components based on company size where a premium is given on smaller companies over larger companies, relative price where value stocks are selected over growth and profitability where more profitable companies are overweight.

Related: Institutional Smart-Beta ETF Adoption is Quickly Rising

The underlying indices adjust securities by relative price and profitability. The smart-beta indices may overweight stocks with lower relative prices and underweight names with higher relative prices. The index can also adjust for profitability by overweighting stocks with higher profitability and underweighting those with lower profitability.

Additionally, the underlying index implements market-capitalization adjustments where it increases the weights of smaller companies and decreases the weights of larger names. The weighting methodology suggests that the ETFs may follow a more equal-weight tilt with greater exposure to smaller companies than traditional market-cap weighted index funds.

Among financial advisors who are still on the fence over smart beta strategies, 43% of those surveyed don’t fully understand the approach and 27% said the strategies are too complicated, which suggests that the ETF industry still has room to continue educating investors about the potential benefits of factor or alternative index-based ETFs.

Financial advisors who are interested in learning more about multifactor, smart beta strategies can watch the webcast here on demand.