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Using etfs to enhance your returns

A smarter breed of ETFs automates the techniques that professional investors have been using for decades, writes BlackRock’s Dhruv Nagrath.

Technology is changing everything: your humble smartphone has millions of times the computational power of the spacecraft that took humans to the moon, you can go for weeks without withdrawing cash thanks to contactless payments, and apparently drones are now delivering burritos. Technology is transforming every aspect of our lives, and the way we invest is no exception. Exchange traded funds (ETFs) have made it possible to build diversified, low-cost portfolios of thousands of stocks and bonds with just a few trades on the ASX.

However that was just the beginning. Smart Beta ETFs take investing to the next level by automating the techniques that professional investors have been using since the 1930’s. Why settle for the market return (referred to as ‘beta’): you can now seek outperformance at a very low cost. This article examines how.

What drives stock returns?

For many decades, active investors have used ‘filters’ or ‘screens’ to identify attractive investment opportunities. These filters have typically targeted ‘factors’, the underlying drivers of return, in order to seek better performance. For example, two classic factors are size and value. Targeting size means investing in smaller companies – they may be more nimble – while seeking value means buying stocks that are believed to be trading cheaply, with lower price to earnings and price to book ratios relative to the broad market. Two other commonly targeted factors include quality and momentum. Professional investors have sought to outperform the market over the years by targeting one or more of these or other factors. Smart Beta ETFs are transforming investing by allowing investors to easily target these factors.

Table 1 – Factors targeted by iShares Multifactor ETFs

Source: BlackRock, as at 30 September 2017. For illustrative purposes only.

Which factor do I buy?

Each of the above factors tends to be rewarded in different market environments and economic cycles. For example, whereas undervalued companies tend to perform when the economy is in recovery mode, markets tend to favour quality stocks with strong balance sheets during recessions. Indeed, different factors have succeeded at different times, and studies suggest that timing factors is just as hard as picking stocks.

Table 2 – The Cyclical Nature of Factors

Source: BlackRock, as at 30 September 2017. For illustrative purposes only.

Accordingly, one response has been to use multiple-factor or ‘multifactor’ strategies, which provide diversified exposure across the four main factors to give investors the best of each exposure. Individual style factors may zig while the others zag, depending on the market environment, so a portfolio that uses a multifactor approach can potentially benefit in a variety of market conditions. What’s more; over the long-term, combining factor exposures may produce even more consistent results than factor exposures individually.

Does it work?

The aim of multifactor strategies is to provide outperformance over the course of the business cycle, so there may be periods where multifactor strategies underperform the broad market, but historical tests suggest that Smart Beta strategies consistently outperform over longer time periods. The past 12 months have been good for global stocks, the broad market delivering returns of almost 18%*. In the same period, the iShares Edge MSCI World Multifactor ETF (WDMF:ASX) has gained nearly 23%, as depicted in the chart below.

Chart 1 – 1 Year Return: World Multifactor ETF vs Market Capitalisation Weighted Index

*As measured by the MSCI World (AUD) Index, as at 17 October 2017. Performance figures represent past performance. Performance is not indicative of future performance and current performance may be higher or lower than the performance shown. Fund net performance is calculated on a NAV price basis, after fund management fees and expenses, and assume reinvestment of distributions. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index.

What’s next?

Smart Beta ETFs provide investors a low-cost, tax-efficient approach to investing. They can potentially improve investment results and increase transparency, often delivering many of the themes present in professional portfolios at a fraction of the cost. What does the future hold? The demand for smart beta is growing rapidly across both individual and institutional investors, who are benefiting from the increased transparency and efficiency of the ETF structure: a Russell study found that over 46% of asset managers report using smart beta investments. The next wave of smart beta ETFs will likely include more fixed income (bond) exposures, and potentially access to alternatives or portfolios with environmental, social & governance (ESG) considerations. Just don’t expect them to deliver burritos to you.

To learn more about BlackRock and iShares Smart Beta ETFs, click here.