When it comes to exchange-traded funds, the most difficult part for investors may not be deciding which strategy to pursue. It may be understanding the language that describes those strategies.
Smart beta. Multifactor. Quantitative. Self-indexed. What do any of those even mean?
In the interest of bringing the ETF world and the English-language world together, here are some common terms, and what they refer to.
- Smart beta: Mostly a marketing term, a play on the financial term “beta,” which measures a security’s volatility relative to a benchmark, usually one representing an entire market, geography or sector.
Because there was never an agreed-upon definition in the ETF world, however, smart beta has come to represent any ETF that weights holdings by something other than just market capitalization. That includes not only funds that weight holdings based on factors such as a company’s size, book value and trading momentum, but also those focused on a security’s volatility, dividends or corporate-earnings quality—or any other investing idea.
“The term has been a constant source of confusion among investors,” says Michael Venuto, chief investment officer and co-founder of New York-based Toroso Investments. “It lumps in too many things.”
Morrison Warren, a partner at Chapman & Cutler LLP, tells investors: “Lean on the prospectus or summary prospectus. Check the index. Read the white paper.”
- Factor: Spawned by research out of the University of Chicago, factors are attributes of a security that indicate it has the potential to provide a higher risk-adjusted return than the overall market. Early on, attributes such as size, value and momentum were identified as factors that could lead to outperformance, which gave rise to index funds and eventually ETFs that weighted holdings based on such attributes.
However, with endless computing power and limitless data, academics began testing every possible investment statistic for a link to returns, and factor investing evolved into a zoo, University of Chicago economist John Cochrane said in a 2011 address.
Research Affiliates, an early adopter of fundamental investing, has gone so far as to declare that most so-called factors can be ignored. “The sheer variety seems to serve the purposes of publication for [academic] tenure and product creation more than better investor outcomes,” Research Affiliates partners Jason Hsu and Vitali Kalesnik wrote in 2014.
- Multifactor: A stock strategy that attempts to derive returns by including more than one factor. Some of the ETFs that engage in this strategy are fixed, meaning they try to constantly exploit the same two factors; others, such as the $139 million Oppenheimer Russell 1000 Dynamic Multifactor ETF (OMFL), try to shift with the economic tides by weighting value, momentum, quality, low volatility and size based on economic expansion, slowdown, contraction and recovery. How should multifactor ETFs be used? “Carefully,” said ETF.com’s Lara Crigger in a May article that analyzed the over 300 ETFs in the FactSet “multifactor” universe. “Their performance leaves something to be desired, but they appear to meet their promises when it comes to lower volatility and risk reduction,” she wrote.
- Tilt: A more-roundabout way into factor investing that starts with a market-cap-weighted index, and then slightly overweights stocks in the index with certain characteristics. In the case of the $1.3 billion FlexShares Morningstar U.S. Market Factor Tilt Index Fund (TILT) from Northern Trust, there is a “tilt” toward small-cap and value stocks. The term ”tilt” is also used by active managers to describe a preferred style of investing such as value or growth, says Mr. Venuto.
- Quantitative: A strategy in which technology and mathematical formulas drive investment decisions.
“It’s a lot of different things,” writes diligence consultant Tom Brakke at his blog the Research Puzzle. In fact, some say the term could be used to describe any fund that tracks an index.
While factor investing rules the roost in this category, quantitative strategies also include “the emergent areas of artificial intelligence (AI) and machine learning,” says Mr. Brakke, which have led to two actively managed “AI powered” equity ETFs. At their core, however, many quantitative strategies employ methodologies that aren’t transparent, as opposed to published index methodologies that can be tested and replicated (though few try).
- Self-indexed: Asset managers, attempting to remove as many costs as possible from their investment strategies, are sidestepping name-brand index firms, such as S&P Dow Jones Indices, MSCI or FTSE Russell, and bringing out comparable products without licensing fees. This is how Fidelity Investments brought out several zero-expense-ratio funds in August. Mr. Warren says, however, that the SEC is taking a deeper look at the role of index firms, including self-indexers, and related disclosures.
- Leveraged and Inverse and Inverse Leveraged: These types of products generally use core holdings (think the S&P 500) and futures contracts or swaps to provide daily multiple returns of an individual index or sector. Because they reset every day—the goal is to magnify a single day’s returns, long or short, every day—the results can be confusing, and long-term investors are advised to stay away. According to research firm XTF, leveraged ETFs run from 1.25 times to 4 times; inverse ETFs attempt to deliver minus 1 time the daily index performance, while inverse leveraged ETFs can run from minus 0.5 time to minus 4 times. Got it?
- Thematic: A step beyond industries and sectors, thematic investing is the flavor du jour in ETF land, especially for equities in up-and-coming industries. Often but not exclusively index-based, thematic investing looks across sectors for companies that are being affected by a market shift or disruptive technology such as robotics or AI. Funds in this arena include ARK Genomic Revolution Multi-Sector ETF (ARKG) and the $1.9 billion First Trust Cloud Computing ETF (SKYY). Proponents say thematic funds can be a cheap and easy way to harness an emerging trend or innovation, but pay attention to the range of holdings and weights.
- Hedged: A general term to imply some level of risk control, often using short selling, options, futures or swaps. A few years ago, ETFs that attempted to capture international equity returns while eliminating short-term currency fluctuations were all the rage. Now, the hot trend is fixed-income products that manage interest-rate and duration risk.
Then there are the old reliables, but even they are getting harder to define:
- Active: This term generally implies an old-fashioned investment strategy, where managers research and pick securities to try to outperform a benchmark index or manage downside risk. Unfortunately for investors seeking clarity, a series of ETFs from Goldman Sachs Asset Management dubbed ActiveBeta might leave some questioning what “active” really means. The ETFs in this case engage in a multifactor strategy combining value, momentum, quality and low volatility.
- Passive: A catchall term for index-tracking funds and ETFs, “passive” is also used to describe other products and strategies that generally remove day-to-day discretion by a fund manager. The barrier between active and passive for ETFs is breaking down, however. In this summer’s proposed ETF Rule, the Securities and Exchange Commission said it would no longer differentiate between active and passive fund applications.
|For more news you can use to help guide your financial life, visit our Insights page.|