Beware of taking labels at face value
Sebastian Ceria and Melissa Brown warn that exchange-traded funds with similar labels can generate widely different returns because of the way their portfolios are constructed
Smart beta has had a foothold in the foreign exchange market for years, although the approach is less pervasive than those of other asset types and it rarely gets called by that name. There are certainly arguments for the presence of risk factors, most notably the currency carry, which investors have long sought to exploit.
What’s in a name? For smart beta exchange-traded funds (ETFs), let the buyer beware, as funds of the same name may not generate returns as sweet.
ETF fund families rely on common themes to create single-factor smart beta ETFs. The objective is to capture systematic returns using a rules-based approach that is transparent and replicable. Yet, while many ETFs have similar labels, such as ‘US Large-Cap Value’ or ‘High Dividend Yield’ they are unlikely to deliver similar returns.
Why? Portfolio construction is often the culprit. Portfolio-construction rules and methods vary widely from one ETF to the next, and those variations can significantly affect performance. Variables include:
• The universe of stocks from which the provider chooses.
• The scheme for weighting assets – market capitalisation, equally weighted, or some other method.
• The number of names allowed in the portfolio.
• Whether other factors (such as sector exposures) are constrained.