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When It Comes to Smart Beta ETFs, It Is Important to Look Under the Hood

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The ETF industry has experienced some innovations in alternatively-weighted indices that can now help investors focus on company fundamentals to help improve outcomes.

In the recent webcast, It’s Fundamental: The Difference Between Smart Beta and Intelligent Beta, Rene Casis, ETF Portfolio Manager, American Century Investments, and Sandra Testani, Director of Product Management – Alternatives and ETFs, American Century Investments, outlined the growth of the ETF industry and underscored the rise of smart beta or factor-based strategies. Strategic beta ETFs have grown to 21% of the total ETF universe in 2019 from just 10% of the total ETF assets.

As the smart beta ETF category expands, investors are faced with increasing number of choices. It is important to hone in on strategies that fit with an investor’s portfolio and investment goals. For example, American Century Investments argued that when it comes to intelligent beta, it’s all about the fundamentals. Specifically, the money managers take a systematic approach that emphasizes company fundamentals, seeking to capture drivers of performance like quality, growth, value and income. These factors can potentially offer superior risk-adjusted returns over a market cycle. For example, high-quality stocks have historically outperformed low-quality stocks by a wide margin.

No two ETFs are the same. Different fund sponsors also measure quality differently, so it is up to the investor to do their due diligence and figure out how they want to access the markets. For instance, BlackRock’s iShares focus on return-on-equity and earnings variability. Goldman Sachs targets gross profit and total assets. Invesco screens for return-on-equity, accruals ratio and financial leverage, J.P. Morgan underscores return-on-equity.

“Unlike many Smart Beta providers, American Century does not treat Quality as a factor,” the strategists explained. “Our Intelligent Beta methodology starts by screening out low-quality stocks based on fundamental measures.”

Specifically, American Century’s quality screening criteria includes measures for profitability, earnings equality and leverage to assess a company’s fundamentals. Furthermore, the screens include earnings revisions to improve purchase timing and management quality to assess corporate stewardship. The quality screen would then eliminate the bottom 20% of the universe and sector based on a quality score.

The American Century STOXX U.S. Quality Value ETF (NYSEArca: VALQ) stock selection process includes a value score based on value, earnings yield and cash flow yield, along with a sustainable income score based on dividend yield, dividend growth and dividend coverage.

The American Century STOXX U.S. Quality Growth ETF (NYSEArca: QGRO) stock selection process is broken down into high-growth stocks based on sales, earnings, cash flow and operating income, along with stable-growth stocks based on growth, profitability and valuation metrics.

Lastly, the American Century Quality Diversified International ETF (NYSEArca: QINT) combines both high-growth and value aspects, selecting stocks based on historical growth, expected growth, profitability, price momentum, valuation and yields.

“Portfolios seek to capitalize on market inefficiencies and shifting dynamics,” the strategists added. “Dynamic adjustments are guided by a set of market and economic signals selected for each asset class.”

While growth and value styles have been viewed as a clean split of a broader index, Hamish Seegopaul, Head of Index Solutions, Axioma, argued that some growth and value indices allow both overlap and omissions of their base universe, such as the underlying benchmarks for VALQ and QGRO. The non-symmetric contributions of the two opposing styles has actually helped both the quality growth and quality value strategies outperform a large-cap benchmark over the last 15 years, and combining the two strategies in a portfolio could produce a more diversified outperformance.

“The Quality Value Index allocates dynamically to a value and an income strategy; the Quality Growth Index allocates dynamically to both a high-growth and a stable-growth strategy. The allocation of the strategies is governed by a risk-adjusted momentum signal,” Seegopaul explained.

“A combination of screening for quality, optimized construction and diversifying among sub-strategies can yield benchmark outperformance,” he added.

Financial advisors who are interested in learning more about factor-based investment strategies can watch the webcast here on demand.

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