This month saw many investment professionals gathering for the Inside ETFs conference. The conference features a wide variety of education, advice, and panels on the state of the ETF and investment industry. One of the more interesting facts to come from the conference is that investors are quickly adopting smart-beta ETFs as replacements for underperforming active mutual funds.
In fact, according to a Brown Brothers Harriman survey of respondents at the conference, more than one-third highlighted the fact that they purchased a smart-beta ETF to replace an actively managed mutual fund.
And you should probably join them.
Smart-beta ETFs use various factors or rules to build-out their portfolios/indexes. Because of this, they blur the line between traditional index investing and active management. The best part is, they are a heck of a lot cheaper than many mutual funds. Thereby, providing better performance.
For investors building a portfolio, using smart-beta ETFs could result in better returns and better long-term outcomes. With that, here are five smart-beta ETFs that could find a home in your portfolio and replace your active mutual funds.
iShares Edge MSCI Multifactor USA ETF (LRGF)
The crux of smart-beta ETFs comes down to their use of factors to develop their portfolios. This includes everything from stocks that exhibit low-volatility or size to those that feature high relative strength or “value.” The idea is that honing in on various factors will help a smart-beta fund outperform a regularly weighted index. But, like anything else in the investment world, not every factor will outperform at the same time. Choosing the right one at the right time could be a fool’s errand.
And that’s why the iShares Edge MSCI Multifactor USA ETF (NYSEARCA:LRGF) could be one the best starting places for investors.
LRGF tracks the MSCI USA Diversified Multiple-Factor Index. This index combs through large-cap U.S. stocks for the four main determinants of overall success: financially healthy firms, stocks that are inexpensive, smaller companies and trending stocks. Better known in the smart-beta world as quality, value, size, and momentum. LRGF then chooses 150 with the highest scores in each category. What you get is a portfolio of the market’s overall best. Current top holdings include Cigna (NYSE:CI) and Marathon Petroleum (NYSE:MPC).
The proof is in the pudding, the smart-beta ETF is up nearly 30% since its inception back 2015. The best part is, LRGF is dirt cheap at just 0.20% in expenses. That makes it an ideal ETF to own over the longer haul.
Vanguard U.S. Liquidity Factor ETF (VFLQ)
When it comes to factors, there are countless ETFs that track the big ones like value or size. However, there is one factor that most investors — and smart-beta ETFs — ignore. And that would be liquidity.
According to Investopedia, liquidity is defined as “the degree to which an asset can be bought or sold in the market without affecting the asset’s price.” The idea behind the liquidity factor is that those stocks that aren’t easily bought and sold can command a premium over those more frequently traded or more liquid equities — if held for a long enough period. There’s plenty of evidence for this.
The only smart-beta ETF looking at liquidity is the Vanguard U.S. Liquidity Factor ETF (BATS:VFLQ). VFLQ digs through the Russell 3000 — which is a total market measure of large-, mid- and small-cap stocks in the U.S. The ETF then looks for the most illiquid stocks in the index based on trading data. The nearly 889 holdings are vastly different make-up than its broader parent.
Being less than a year old, it’s hard to tell just how the new ETF will do. Likewise, itself is pretty illiquid and features only about $20 million in assets. However, as word gets out about the ignored liquidity factor, the ETF should garner assets in the future. The Vanguard-low expense ratio of just 0.13% won’t hurt either.
Smart-Beta ETFs To Buy: Goldman Sachs Access High Yield Corporate Bond ETF (GHYB)
If there is one area of the market that smart-beta ETFs can really thrive it’s in fixed income and bond investing. That’s because traditional bond indexes are weighted by the amount of debt issued. So, a firm with the most IOUs will typically be the largest holdings in many bond ETFs. That’s kind of counter-intuitive. There’s a vast difference in credit quality and the amount of debt owed. And unfortunately, broad bond indexes don’t discriminate against “good” debt and those with “bad.”
This is an even bigger problem when looking at junk bonds and high-yield debt. With their focus on fundamentals and factors, smart-beta ETFs are made for fixed income. And the Goldman Sachs Access High Yield Corporate Bond ETF (NYSEARCA:GHYB) could be a great ETF in the sector.
GHYB sets itself apart from junk-bond ETF rivals like the popular SPDR Bloomberg Barclays High Yield Bond ETF (NYSEARCA:JNK) by using various screens to eliminate firms with shaky or deteriorating financials. High-yield bonds already come with a hefty amount risk. They don’t call them junk bonds for anything. But, if you can kick-out those firms that are experiencing lower revenues or sinking cash flows, you have a better chance of making money and not losing it.
For income seekers, this allows for a bit of safety as well as high yield. GHYB currently has a 30-day yield of 6.16%. This yield and stability can be had for a low active mutual fund beating 0.34% in expenses.
Invesco S&P 500 Quality ETF (SPHQ)
Pop the hood on most active mutual funds and there’s a good chance that managers look for stocks with rising revenues, strong dividends, the potential for growth, etc. The hallmarks of so-called quality stocks. And that makes these active mutual funds prime candidates for smart-beta ETFs.
One of the oldest quality stocks funds in the sector is the Invesco S&P 500 Quality ETF (NYSEARCA:SPHQ).
Launched in 2005, SPHQ tracks the S&P 500 Quality Index. This index digs through the bread and butter index and looks for stocks that score high on three measures: return on equity, accruals ratio and financial leverage ratio. Basically, stocks that getting the job done and are doing so with increasing cash flows and low debts. SPHQ then selects the top 100 stocks in the index to include in the fund. Currently, tech dominates at 40% of assets, with healthcare stocks at a distant second place at just 11% of AUM.
Performance for the ETF has been mixed over the years. But that’s mostly because SPHQ used to track two different indexes: the Value Line Timeliness Select Index and the S&P 500 High-Quality Rankings Index. The switch to its current index was a smart move as the S&P 500 Quality Index has long been a top performer vs. the regular S&P 500.
With expenses of just 0.15%, SPHQ is a great addition to a portfolio and replacement for many active large-cap mutual funds.
Fidelity Dividend ETF for Rising Rates (FDRR)
One of the earliest styles of smart-beta ETFs to hit the market has been dividend-focused funds. The Fidelity Dividend ETF for Rising Rates (NYSEARCA:FDRR) is the latest incarnation of those ETFs.
Dividend stocks and ETFs loose some appeal in the rising rate environments like today. Investors flee these higher yielding instruments for safer bonds as the Fed raises. However, historically, dividend growers have increased their payouts at faster rates than measures of inflation and interest rate hikes. These sorts of stocks continue to do well as the Fed increases benchmark rates.
And that’s what FDRR does.
The ETF tracks a proprietary smart-beta index that follows a basket of large- and mid-cap dividend growth stocks that have a positive correlation of returns to increasing 10-year U.S. Treasury yields. In a nutshell, FDRR combs through all the dividend-paying stocks out there and finds the ones that actually see increased buying activity thanks to their dividend growth as the Fed raises rates. You’re basically getting high income and the ability to see that income grow over time.
Given the Fed’s pace of rate hikes, FDRR could be a wonderful smart-beta ETF to replace an expensive equity income fund in your portfolio.
At the time of writing, Aaron Levitt owned a long position in LRGF.