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

Minimum volatility

chart showing minimum-volatility-smooth-line-chart

Momentum ETFs try to dampen or lower the size of the random 'ups' and 'downs' of the sharemarket. For example, if the sharemarket falls 5% they would try to fall by less than that (e.g. 2%). 

There are quite a few ways these ETFs try to minimise volatility (the academic's version of investing 'risk'). For example, an Australian shares minimum volatility ETF might attempt to lower risk by using complex 'derivative' strategies (similar to managed risk hedge funds) or by simply buying shares with low 'beta' ratios.

Remember, volatility is a type of 'risk' created by intellectuals/academics, TV broadcasters and our impulsive monkey brains. So if you understand how the sharemarket really works or you have been in the market long enough, you'll know that volatility is not a real measure of risk and it really doesn't matter to long term investors.

It's not the journey (ups and downs) but the destination (your returns) that count!

Our take: don't be fooled by minimum-volatility rules-based ETFs!

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, 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.

Our take: don't be fooled by income-focused rules-based ETFs!

Momentum ETFs

chart showing newtons cradle and how momentum-etfs work

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

Oftentimes, momentum ETFs 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 a year it would get a bigger position in a momentum ETF portfolio than a share that went from $5 to $4. 

We note there is rigorous evidence which explains why, how and when momentum strategies can work. For example, these ETFs capture 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!

Our take: momentum strategies might work in some markets, but we believe they're not a 'must have' in a long-term focused investment 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 perform better.

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

Basically, if there's a reliable data source on valuation factors from a company's financial statements, chances are, 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, it would be a mistake to avoid highly-valued shares.

Our take: don't be fooled by value 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 they rebalance. 

Equal weight strategies are different to 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 - 200th) and less exposure to the largest shares (1st - 100th).

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 they have more risk because they are investing more in smaller companies. Another concern is that they have less exposure to the biggest and best shares (the ones growing the quickest). 

Our take: consider equal weight ETFs for a smaller position alongside traditional ETFs in Australian shares and local and global bonds. 

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 because they often use multiple rules, filters and strategies to create one portfolio. 

Our take: don't be fooled by multifactor ETFs! Not only are many of them unlikely to work, you're more likely to panic when markets fall because you don't understand how the ETF works!

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