With market cap weighted total index funds becoming so concentrated in less than 10 companies of the US stock market, fears about concentration might be warranted.
Is there space for a less subjective, more systematic approach to investing?
I don’t want to:
- try to outguess the market, my aim is to minimize mistakes and the number of trades;
- chase past performance, a careful assessment of the risk/loss profile historically delivered better results;
- work for my investments, the market works for me when I practice smart diversification.
I could achieve such a result by adopting a smart-beta investing approach.
What is Factor / Smart-Beta Investing?
Factor investing is an investment approach that targets specific drivers of return across asset classes. Common factors include value, momentum, quality, size, yield and volatility. Investors use these factors to construct portfolios that aim to achieve better risk-adjusted returns than traditional market-cap-weighted indexes.
- The volatility factor overweights assets with more stable price movements over time.
- The quality factor overweights assets with strong balance sheets, low debt, and high profitability.
- The momentum factor overweights assets with the best performance over the past 6 to 12 months.
- The value factor overweights assets that appear undervalued relative to their fundamentals.
- The size factor overweights assets with smaller market capitalizations, which tend to outperform in the long term.
- The yield factor overweights assets that offer significant and sustainable distributions.
Smart-beta investing refers to strategies that use alternative index construction rules (other than market capitalization) to capture factor exposures systematically. Smart-beta ETFs often track indexes that tilt toward one or more factors, such as value or low volatility.
- Factor investing is the broader concept of targeting specific return drivers in a portfolio.
- Smart-beta is a practical implementation of factor investing, typically through rules-based, transparent index products that systematically capture factor exposures.
The European way
Here we’ll look at how to construct a European version of a portfolio with factor tilts and ETFs to use.
It’s an imperfect and lazy portfolio that utilizes globally diversified index funds plus factor tilts, particularly for Size and Value, with an embedded home bias.
- 50% EXUS / Xtrackers MSCI World ex USA UCITS ETF 1C / IE0006WW1TQ4 / Ter: 0,15% p.a.
- 10% AVWS / Avantis Global Small Cap Value UCITS ETF USD Acc / IE0003R87OG3 / Ter: 0.39% p.a.
- 10% ZPRX / SPDR MSCI Europe Small Cap Value Weighted UCITS ETF / IE00BSPLC298 / Ter: 0,30% p.a.
- 10% ZPRV / SPDR MSCI USA Small Cap Value Weighted UCITS ETF / IE00BSPLC413 / Ter: 0,30% p.a.
- 10% YGLD / IncomeShares Gold+ Yield ETP / XS2852999775 / Ter: 0,35% p.a.
- 10% YSLV / IncomeShares Silver+ Yield ETP / XS3068774614 / Ter: 0,35% p.a.
- 0% EMXC / Amundi MSCI Emerging Ex China UCITS ETF Acc / LU2009202107 / Ter: 0,15% p.a.
Average total expense ratio: 0.15 * 0.50 + 0.39 * 0.10 + 0.30 * 0.10 + 0.30 * 0.10 + 0.35 * 0.10 + 0.35 * 0.10 = 0.244% p.a.
Even if market timing is avoided, choosing to overweight certain factors can be an implicit form of timing, especially if allocations are changed over time or in response to recent performance.
A European “home bias” may reduce diversification and increase portfolio-specific risk compared to a purely global exposure. When adopting value and size factors, some sector or geographic concentrations will occur.
Including covered call ETPs on precious metals is generally not considered a sound financial strategy. Covered calls tend to underperform over the long term. This allocation may only be beneficial if you specifically require this type of dividend for tax reasons (e.g. preferring other forms of income over capital gains).
References
John Cassidy - The New Yorker - Is the A.I. Boom Turning Into an A.I. Bubble?
Benjamin Felix - PWL Capital Inc - Factor Investing with ETFs