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How to Choose a Strategic Beta ETF

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Demand for strategic beta ETFs has been rising among RIAs and independent broker-dealers as either a complement or alternative to active management strategies to reduce portfolio risks and amplify returns, in that order, says John Feyerer, director of equity product strategy at PowerShares, Invesco’s ETF division. 

With interest rates expected to rise this year along with a stronger economy, strategic beta ETFs focusing on value and size (market cap) factors should perform well, says Feyerer, who participated in a recent conference call sponsored by Schwab ETF OneSource.

Tony Davidow, alternative beta and asset allocation strategist at the Schwab Center for Financial Research, agrees that a  “value tilting” will do well this year, as well as fundamental smart beta strategies, which assign the heaviest weights to securities based on factors such as sales, cash flow, dividends and buybacks.

Advisors can choose strategic ETFs that focus on one of these other single factors, depending on the overall risk and performance appetite of their clients, or choose a multi-factor ETF instead.

A multi-factor ETF provides a broad allocation of assets, but a single-factor ETF has the potential to yield higher returns, adding more alpha as well as more risk, according to Mike Akins, head of ETFs at ALPS, the fourth largest distributor of ETFs in the U.S.

One way to hedge that risk, says Akins, is to pair two different single-factor ETFs that are negatively correlated for excess returns, which are returns above a benchmark index. They are likely to move in opposite directions.

Another variable to consider when choosing a strategic ETF is active share, essentially those holdings that constitute the strategic or smart components, and, when choosing multiple ETFs, the overlap of active share, says Akins.

He notes that the active share of the S&P 500 Pure Value index, which are the cheapest stocks in the S&P Value Index, accounts for about 80% of its assets, or twice the active share of the more plain vanilla S&P 500 Value index. Over 20 years, the Pure Value index also outperformed, adding almost 3% of annualized outperformance, but with substantially more risk, says Akins.

A pure value strategy is also more concentrated. Guggenheim’s S&P 500 Pure Value Index has 116 stocks compared with 352 in iShares S&P 500 Value ETF.

When choosing strategic beta ETFs, it’s important to define their role in a broader portfolio, said Schwab’s Davidow. They have the potential to deliver diversification and risk-adjusted excess returns at low cost with little tracking error plus the ability to make tactical shifts, but the choice depends on “who the user is,” says Davidow, adding that “sophisticated RIAs” can use the strategic beta ETFs “to build better portfolios.”

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