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Rules Based ETFs Explained

What is a Smart Beta / Rules-Based / Factor ETF?

factor etf chart showing two different lines

Smart beta ETFs are the same thing as 'Rules-Based' and 'Factor' ETFs. Smart beta ETFs change or modify the risk and return characteristics of a normal market index fund.

How do they change the return and risk?

factor etf chart showing two different lines

They do it by creating a set of 'rules' that determine which investments are bought and sold by the ETF.

For example, an income-focused rules-based ETF might invest only in shares with a dividend yield over 5%.

 Why do some people call them 'Smart Beta'?

picture showing how a rules-based-etf might funell individual stocks

If you have taken a finance course you will remember this thing called 'beta' and that the entire sharemarket for each country has a beta of 1.0. Beta is a measure of 'risk' (as defined by smart people/academics). 

Here's what the numbers mean:

  • A beta of more than 1.0 means more risk
  • A beta of less than 1.0 means less risk

Traditional index funds track the 'entire market', so they have a beta of 1.0.

Since the 'smart' beta ETFs change the risk and return of an investment portfolio (compared to Index funds or 'the market') they have a different Beta (e.g. a beta of 0.6 or 1.5).

Marketing departments did the rest -- 'smart' sounds better!

Types of Rules Based ETFs

Equal Weight Strategies

image of scales showing feet standing on an equal weight level

Equal weight strategies are as simple as they sound. If there are 200 stocks in the ETF, all 200 will be bought in equal measures, or 0.5% each. Every so often (e.g. each quarter or every six months) the ETF issuer will rebalance the portfolio.

rules-based-etfs-asx-market-cap

Equal weight strategies are different from normal index funds because normal index funds use market capitalisation, a measure of a company's size, to weight shares in the ETF. In a normal index fund, the biggest companies get the biggest position in the ETF.

Equal weight strategies can help investors get more exposure to the smaller shares in the index (e.g. shares 101 - 200 out of the top 200) and less exposure to the largest shares (e.g 1 - 100). Depending on your risk profile, goals/objectives and time to invest, these strategies may not produce a better outcome relative to traditional index funds.

Why equal weight?

Most ETFs use strategies that focus on 'market capitalisation', which means the biggest companies (e.g. blue chips) get the biggest position in the ETF/fund. Some researchers believe smaller companies outperform large companies and, therefore, should be a bigger part of a portfolio.

In the Australian shares sector, equal-weight ETFs are popular because the market is concentrated towards the biggest banks/financials and resources companies.

One downside to equal weight portfolios is that they tend to have more risk (as measured by Standard Deviation) because they are investing more in smaller companies. Another concern is that they have less exposure to the biggest and best shares (i.e. the ones growing the quickest).


Income-focused / yield ETFs

image showing a bag of money

Income or dividend-focused ETFs place a higher value on shares with large dividend yields or coupons from bonds. For example, a global shares income-focused (rules-based) ETF might only buy shares with trailing dividend yields of 5% or more.

Unfortunately, investors have to be very careful because the dividend income from these ETFs often comes at the expense of growth! For example, some of these ETFs will buy into shares that are 'value traps' and have a high trailing dividend yield for a reason.

Make sure the income-focused ETF you're looking at isn't going backwards by paying you dividends at the expense of growth (hint: look at the NAV or 'unit price' of the ETF over many years). Talk about robbing Peter to pay Paul!


Momentum ETFs

chart showing newtons cradle and how momentum-etfs work

"Investing is simple: buy things that go up".

Oftentimes, momentum ETFs will simply buy shares that have gone up in price and sell those that have gone down in price.

For example, if company XYZ's share price goes from $5 to $10 in one year it would get a bigger position in a momentum ETF than a share that went from $5 to $4.

We note there is rigorous evidence which supports why, how and when momentum strategies can work. For example, these ETFs can take advantage of the 'herd mentality' bias of investors. Meaning, some investors (especially "traders") buy things that go up in the hope that they'll keep going up.

Final point: momentum strategies are often used 'in addition' with other strategies. For example, as a filtering process for other rules-based strategies.


Multifactor ETFs  chart showing how multifactor etfs work with four bar chats and a line going upwards

Multifactor ETFs use a combination of rule-based strategies to develop a portfolio of shares, bonds or other assets. They get their name from the idea that every investment has multiple factors (e.g. value, momentum, volatility, etc.) and can be mixed together to a make a great portfolio.

In truth, almost all rules-based ETFs are multifactor ETFs. However, you'll know a multifactor when you see one in the wild because they often use multiple rules, filters and strategies to create one portfolio.


Value ETFs

image showing cheap, value or sale tag with scissors

Value ETFs buy shares of companies with a low valuation in the belief that shares which have low valuations tend to perform better.

It's important to note that most value factor ETFs use a simple statistical measure of value which is often as uncomplicated as buying shares with low price-earnings (P/E) ratios or price-book (P/B) ratios.

Basically, if there's a reliable data source on valuation factors from a company's financial statements, chances are, somewhere in the world a rules-based ETF is already tracking it.

There are varying levels of complexity and sophistication in Value ETFs. However, research shows it's often only the top few per cent of shares on the exchange that accounts for almost all of the sharemarket's positive return. Therefore, we think it would be a mistake to avoid highly-valued shares.


 

ETFs by Sector

Australian Shares

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Global Shares

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Australian Bonds

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Global Bonds

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Commodities

 

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