When you see an article about smart beta funds, the first thing that might come to your mind is what does “smart beta” mean?
“Beta” measures the volatility of a security or portfolio in relation to the entire market. Volatility is how we measure risk. The more volatile a security or portfolio is, the more risk there is in that investment. That’s because an investment that, say, moves between -5% and +5% in a year is less volatile and less risky than one that moves between -40% and +40%.
“Smart beta” exchange-traded funds (ETFs) are what I call “half-managed.” Managers select an index to operate of off, and then adjust according to certain criteria that theoretically reduces the risk of the smart beta ETF — hence the term “smart.”
Thus, instead of just using a cap-weighted ETF, a manager may rejigger the portfolio to take advantage of his own knowledge or expertise, or various quantitative data, to reach this goal of reduced risk via smart beta.
With that in mind, here are three smart beta ETFs to buy, depending on the kind of investor you are.
Expense Ratio: 0.58%, or $58 annually per $10,000 invested
One of the important elements in a diversified portfolio is to have international exposure. Another is to have small-cap stocks in your portfolio, since they historically are the best performing sector. Thus, the WisdomTree Europe SmallCap Div Fd (ETF) (NYSEARCA:DFE) is worth a look.
This ETF focuses on both European equities that are also small-caps, and even better, they pay dividends. Thus, given that these companies have the cash flow to pay dividends and that they are still only small-caps, that’s good news.
The smart beta DFE grabs the bottom 25% of all the market caps of the WisdomTree Europe Dividend Index after the biggest three hundred companies are removed. The remainder are weighted, but only according to cash dividend paid on an annual basis.
Expense Ratio: 0.25%
Now, let’s have a look at the big gorilla that everyone owns — the S&P 500. The S&P 500 is up 19% so far this year. However, it’s low-volatility version, the PowerShares S&P 500 Low Volatility ETF (NYSEARCA:SPLV) is up 15%. Over a 3-year period, the S&P is up 10.42% annually vs. 11.16% for the SPLV.
Moreover, the Sharpe Ratio — a measure of risk-adjusted return — is 1.4 for SPLV vs. 1.0 for SPY. What we see, then, is that this year, investors are getting about 270bps less in return but significantly less risk. Over a three-year period, the returns have actually been higher, even with less risk.
The SPLV has a beta of 0.78 — which means it is 78% as volatile as the S&P 500 itself — or it carries 22% less risk.
The reason for this diminished risk is how this smart beta index is constructed. The smart beta SPLV takes only one hundred stocks from the index, and only those with the lowest realized volatility over the past year. Thus, risk is spread out, making SPLV one of the most solid smart beta ETFs to buy.
Expense Ratio: 0.48%
Finally, we have iShares Global Telecom ETF (NYSEARCA:IXP). We’re back to the theme of investing internationally, but “global” also means domestic companies. There can be risk with international stocks because securities laws differ and there can be unstable regimes in charge of some countries.
However, when it comes to telecom, there is a higher degree of security. Many international telecom companies are often state-owned, or the state controls them in some way. They also tend to be monopolies, so cash flow is guaranteed. They do carry a lot of debt, but just like the companies here, the necessity of having telecom service results in consistent cash flow.
In addition, that cash flow usually means consistent dividends. Indeed, this fund pays a 3.92% dividend.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.