Smart Beta ETFs are achieving an increasing popularity, seen as the perfect equilibrium between passive investment and active management. But, what’s the difference between them and the traditional ones? Is it possible to create our own ETF with some previous experience and without assuming higher trading costs? Would it be worthwhile?

Have you ever heard about “Factor ETFs” or “Smart Beta ETFs”? If you are an investor or you work as a financial advisor or asset manager, the answer will probably be yes. Nowadays, these type of ETFs are achieving an increasing popularity among investors.

But, what’s the difference between them and the traditional ones? The Factor Investing approach seeks to improve the risk and/or the return rate by taking into account different factors that historically have earned a persistent premium for long periods of time, instead of only following a specific market or a particular index (such as the S&P or the Euro Stoxx).

After this description, anyone could think that these ETFs are just another complex and expensive stock picking selection strategy. Nothing could be further from the truth: factor ETFs are just somewhere between passive investment and active management. Smart Beta ETFs are not actively managed from the traditional point of view but they will provide more analysis and rebalancing of their composition than traditional index ETFs, what gives them the potential opportunity to outperform a market index.

A short sample from the current wide variety

Value, Size, Momentum, High Dividend, Quality, and Volatility are the main factors currently used and most of the issuers have commercialized ETFs related to these factors:

SPDR® MSCI Europe Value UCITS ETF whose investment objective is to “track the performance of European equities with a higher weighting applied to equities exhibiting low valuation characteristics.”

 iShares Edge MSCI World Size Factor UCITS ETF that “seeks to track the performance of an index composed of smaller capitalization companies within the MSCI World investment universe”.

JPMorgan U.S. Momentum Factor ETF is “designed to provide domestic equity exposure with a focus on companies with strong risk-adjusted momentum and the potential to enhance returns.”

First Trust Value Line Dividend Index Fund “seeks investment results that correspond generally to the price and yield of an equity index called the Value Line® Dividend Index which is a modified equal-dollar weighted index comprised of U.S. exchange-listed securities of companies that pay above-average dividends and have potential for capital appreciation.”

Invesco S&P 500® Quality ETF “tracks the performance of stocks in the S&P 500® Index that has the highest quality score, which is calculated based on three fundamental measures, return on equity, accruals ratio and financial leverage ratio.”

iShares MSCI Japan Minimum Volatility ETF “seeks to track the investment results of an index composed of Japanese equities that, in the aggregate, have lower volatility characteristics relative to the broader Japanese equity markets.”

This is only a short sample from the wide variety we could currently find in the ETFs market.

But, would it be possible to create our own Factor ETF? As the Factor Investing is based on an investment strategy, radically different from high-frequency trading, and, as the underlying assets are easily accessible in many trading platforms, is not presumptuous from us to assume that we could create it with minimum trading costs.

Our own S&P 500 Momentum ETF

We are going to choose the Momentum factor. Momentum investing is all about buying into trends and usually refers to the force or speed of movement.

Although momentum is not a long-term phenomenon, according to the literature, companies with higher momentum are characterized by a higher price performance in the quite recent history and they tend to continue its trend over the short-medium term.

We select the S&P 500 stocks universe to apply our factor investment strategy ETF, which essentially consists of applying the following algorithm twice a year:

1. Calculate a momentum estimator based on data from the previous 6 to 12 months.
2. Correct the previous estimator with a coefficient based on the volatility.
3. Calculate the number of assets necessary to cover a predetermined percentage of the market capitalization from the parent index.
4. Rank the index components by the result of the estimator calculated in the two first steps.
5. Select the number of assets determined in step three at the top of the ranking.
6. Assign weight proportionally to the estimator.

Applying this strategy over the components of the S&P 500 since the 31^st of May of 1999 and discounting a transaction fee of 0.05% per trade and a 0.60% in concept of yearly management fee, we obtain the following results:

It seems then that the “do it yourself” option provides a simple and inexpensive way to create our own Momentum ETF with an attractive result in terms of risk and return.

Key requirements for creating a Momentum Factor ETF

Seeing the graph and the results above, it could be seen as an easy, simple and inexpensive way to create a Momentum ETF with an attractive result in terms of risk and return. But, there are some key requirements to do it in a proper way:

• Have experience trading with ETFs.
• Have the scientific knowledge to design the algorithms in which the quantitative investment process is going to be based on.
• Have access to the right data, historical and daily updated price series, from all the companies included in the S&P 500 universe.
• Have access to any trading platform.

Would it be worthwhile?

Not for us. Despite the attractive returns generated by our own “recently created S&P 500 Momentum ETF”, we would discard it, because of the higher risk associated with it. For us, it would be necessary to implement control risk measures in order to moderate the drawdowns in bearish markets, following the saying: “Who loses the least, wins the most”. But, that will be the case for another post.