New-to-Market - This blog series highlights ETFs that have recently gone public and reflect those strategies currently most in demand by investors. While ETFs are not eligible for ETFG Risk Ratings until traded for 3 months and ETFG Reward Ratings for 12 months, our goal is to highlight the most cutting-edge investment strategies that have recently embraced the ETF structure – we hope you enjoy this special series of posts.
One trend that became clear during the recent Spring 2015 ETP Forum was that smart beta has been seen by many large investors as a natural progression from the first indexed ETFs. And while John Bogle may question just how “smart” smart beta actually is, the factor exposure and transparency these funds offer larger investors has helped draw billions into the new asset class. So for this “New-to-Market” post, we’re investigating the ETFS Diversified-Factor U.S. Large Cap Index Fund (SBUS), a fund that seeks to bridge the divide between the worlds of smart beta strategies and actively managed ETF’s and might just be the first step in the next evolution of the strategy.
Like most “smart beta” funds, SBUS offers a transparent, rules-based system and clear methodology that distinguishes it from a passive investment but the similarities between the fund and its peers end there. Since the dawn of smart beta funds, most were typically built either as an equally weighted fund or offered exposure to a specific factor such as momentum or low volatility, but the developers of SBUS decided to use a best ideas approach and create a fund that combined those two methodologies in a single fund.
Starting with a universe of 500 of the most liquid securities, the fund’s benchmark, the ‘Scientific Beta United States Multi-Beta Multi-Strategy Equal Weight Index’, first screens based on the four most academically accepted violations of the efficient market hypothesis: low valuations, low volatility, size and momentum. Once the universe has been ranked, the fund uses a unique weighting system that seeks to maximize the Sharpe ratio by focusing on both minimalizing volatility and tracking error from market benchmarks like the S&P 500 or the Russell 1000. While the number of index holdings (currently 485) might lead some to conclude that the fund follows a simple equally weighted approach investors expecting the fund to closely track the S&P 500 from day-to-day are likely to be disappointed as the fund’s allocation differs significantly from the S&P 500.
Given that two of the documented market anomalies used in the funds construction are low volatility and value as well as the weighting scheme that favors low correlation, it doesn’t come as much of a surprise that a large percentage of the index is made up of more “defensive” names with utilities representing nearly 11% of the index compared to a mere 3% for the S&P 500 with much of the difference coming at the expense of highflying healthcare names trading close to peak valuations. That lower weighting helped cushion the downdraft in the market that began on March 20th and bottomed out on April 6th when the Healthcare Select Sector SPDR (XLV) lost 3.31% while SPY lost .8% and SBUS a mere .3%. Like well-known low volatility funds such as the PowerShares S&P 500 Low Volatility Portfolio (SPLV), the low volatility/low valuation focus isn’t expressed solely though defensive holdings as the largest sector allocation goes to the financials that comprise nearly 20% of the index compared to 14.6% of the S&P 500.
While the fund’s performance history is limited, it has so far shown signs of living up to its creator’s intentions. After a lackluster first month in February where the overweight towards utilities had weighed down performance relative to its peers, that same position helped lift the fund far above the market in March with the fund up .15% compared to a 1.58% loss for the S&P 500 while most of the funds in its category delivered an uninspiring -1.10%. What remains to be proven is whether the fund can deliver on lower volatility with only minor tracking error. The ETFG Red Diamond Risk System does show SBUS having a reduced deviation score of 5 compared to 6.46 for SPY, but lower tracking error might be beyond the funds reach. Thanks to the focus on non-correlation, the fund’s NAV has been fairly steady since late February while the market has been gyrating wildly as sector rotation takes hold. The jury is still out for those investors seeking both lower volatility and tracking error but for those who can afford to stray from the benchmark; this might be a fund worth watching.
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*Please note that ETFs are eligible for ETFG Red Diamond Risk Ratings following 3 months of trading and ETFG Green Diamond Reward Ratings following 12 months of trading.
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