Smart Beta ETF

Part 1 What is Smart Beta & Quality ETF

Reading time: 8-10 minutes

Table of contents

• What is a smart beta ETF?
• Categories of Smart Beta ETF?
• Z-Value
• Methodology Quality ETF
• Conclusion and outlook

Disclaimer: No investment advice or recommendation, this article is for information purposes only. Before you decide on an ETF, take a closer look at it in terms of positions, sampling, regions, etc. I can't describe everything here as it would go beyond the scope of this article.

What are smart beta ETFs?

To understand smart beta ETFs, it is first important to know what "beta" is. Beta is a financial ratio that measures how much an asset/share (or a group of shares) fluctuates in relation to the underlying market. Simplified: if the German stock market has a volatility of 16 % and the DAX of 10 %, then the beta is 1.6.

The reference value for the beta is therefore the market. For "normal" ETFs, the beta should be close to 1, as the iShares Core MSCI World ($IWDA), for example, attempts to replicate the MSCI World Index and both are weighted according to market capitalization (not quite 1 due to tracking difference).

In contrast, smart beta ETFs attempt to achieve a higher return or lower risk (volatility) by selecting a different stock from the underlying market capitalization-weighted index (beta), e.g. by equal weighting or applying certain parameters such as price/earnings ratio or price/book ratio.

In addition to smart beta, there are also terms such as "tilt" or "enhanced" for this "smart" stock selection, i.e. the determined over- or underweighting of various characteristics.

Smart beta ETF categories

Roughly speaking, smart beta ETFs can be divided into the following categories:

• Quality (approx. 12 billion invested volume)
• Value (approx. 12 billion invested volume)
• Low Volatility (approx. 8 billion invest volume)
• Momentum (approx. 4 billion invest volume)
• Multi-factor
• Growth & Small-Cap (approx. 12 bn Investvol)
• Dividend (approx. 16 bn Investvol.)
• Equal-Weight

Even if one or the other strategy has been mentioned several times before, it is surprising that the investment volume of all smart beta ETFs is lower than that of the $IWDA (+0,23%) (EUR 73 bn)

So what is the approach behind the individual smart beta ETFs and could this present an interesting investment opportunity? To find out, let's take a look at the individual tilts and their methodology.

The Z-value

In order to understand the methodology of Smart Beta ETFs, it is necessary to deal with the so-called Z-value, as MSCI in particular seems to have fallen in love with this parameter for its Smart Beta ETFs.

The Z-value is a figure that shows the number of standard deviations of a data point (e.g. P/E ratio) from the mean value. In this respect, it is a ratio that compares the key figure of an individual stock with the key figures of all stocks in the index.

Simplified example based on P/E ratio

Share A: 10

Share B: 15

Share C: 20

Share D: 50

Mean value: 24

Standard deviation: 15.67

Z-value A: -0.88 (read: P/E ratio of 10 is 0.88 standard deviation below the mean)

Z-value B: -0.56

Z-value C : -0,24

Z-value D: 1,69

If the ETF now wants to overweight shares with a low P/E ratio, for example, it would weight the shares with the lowest Z-value higher.

If you are still stumped by this example - like a clumsy fireman - we recommend the following video:

z-Standardisierung (z-Transformation)- Einfach erklärt - DATAtab

Now to the individual categories, each showing a selection of the largest ETFs:

Quality ETF

Overweighting of companies with solid fundamental indicators such as high return on equity, stable earnings growth and low debt.

💰 Z-Score MSCI Quality ETF

There are 4 larger ETFs with the same methodology but focusing on different regions (TD = tracking difference):

• $IS3Q (+0%) (World | TER 0.30 % | TD 0.10 % | 3.5 bn Invest | 3Y outperformance vs World + 1,5 %.)
• $IUQF (+0,27%) (World | TER 0.25 % | TD 0.04 % | 1.7 bn | 3Y outperf. vs. world + 1,7 %.)
• $XDEQ (-0,05%) (USA | TER 0.20 % | TD n.a. | 1.9 bn | 3Y outperf. vs. S&P 500 + 0,3 %.)
• $IEFQ (-0,99%) (Europe | TER 0.25 % | TD 0.0 % | 3Y underperf. vs. Eurostoxx 600 - 4,1 %).

Index methodology:

• The ETFs are based on respective "parent indices", e.g. the MSCI World.
• In the first step, the variables are named for the quality ETF:
• Return on equity (12-month earnings per share [EPS] / latest book value per share [BVPS])
• Leverage ratio (total debt / book value)
• Stable earnings growth (measured by variability [standard deviation] of y-o-y eps for the last 5 years)
• The Z-value (see above) is determined for each share for the individual key figures
• Extreme values are then eliminated
• The Z-values are then added together for each share
• The shares with the highest total Z-scores are included in the ETF
• Rebalancing takes place every six months

On a site note: if you want to save some TER, you can use the Xtrackers ETF, these are usually 0.05% TER cheaper than the iShares counterpart with a similar tracking difference & are based on the same index & calculation logic.

💰 Wisdom-Tree-Quality-ETF

Track dividend payers with higher growth prospects at the same time

• 
  $GGRG (+0,04%) (World | TER 0.38 % | TD 0.32 % | 0.7 bn | 3Y Underperf. vs. World -2 %.)
• 
  $DGRG (+0,06%) (USA | TER 0.33 % | TD 0.02 % | 0.4 bn | 3Y outperf. vs. S&P 500 + 7,1 %.)

Index methodology:

• Variables:
• Growth factor: based on expected earnings growth (expectet eps)
• Quality factor: based on the last 3 years return on equity (ROE) and return on assets (ROA)
• Stability factor: earnings per share (EPS) must be higher than dividend per share (DPS)
• Exclusion criterion: Companies that do not meet Wisdom-Tree's ESG criteria are excluded
• Weighting: After the variable filter, the companies in the index are weighted according to the annual dividends paid
• Rebalancing takes place every six months

💰 Invesco RAFI Index:

• $PFT (+0,5%) (USA| TER 0.39 % | TD 0.33 % | 0.5 bn | 3Y underperf. vs. S&P 500 - 2,7 %.)
• $PEH (-0,08%) (EM | TER 0.49 % | TD n.a. | 0.04 bn | 3Y Outperf. vs. Emerging Markets IMI + 10,8 %.)

Index methodology:

• Variables:
• Cash flow, sales & dividends: Weighting from average values of the past 5 years and current book value
• The index weights are determined in proportion to the fundamental values of the companies. Calculation: fundamental values / market-capitalized free-float values.

Conclusion on the Smart-Beta Factor Quality

In the first part of this series, we looked at quality ETFs. The smart component consists of screening the stocks contained in the "parent index" according to quality factors such as earnings growth, leverage, book value, etc. and weighting them on the basis of their relative strength compared to the other stocks contained in the index.

If you want to track the world index, I would recommend the $XDEQ (-0,05%) However, the difference to the normal MSCI World is not so great that one could speak of real diversification.

I also find the smart beta approach exciting in order to set the focus of the smart beta ETFs differently on geographically different markets (e.g. USA Large CAP/Momentum, Europe: USA Large CAP/Momentum, Europe: Small CAP & Growth, Emerging Markets: Quality & Value). Unfortunately, the only Emerging Markets Quality ETF has a very low investment volume of only around EUR 40 million. Those for whom this is not an obstacle are welcome to take a look at the $PEH (-0,08%) as it has clearly outperformed the MSCI Emerging Markets and, in my view, quality factors can make good use of their opportunities, especially in such markets.

In the next parts, we will look at the other classes of smart beta investing - stay tuned!

Many users here are rightly enthusiastic about dividend growth ETFs.

The most popular are probably:

Fidelity Global Quality Income $FGEQ (+0,06%) and

WisdomTree Global Quality Dividend Growth $GGRG (+0,04%) / $GGRP (-0,09%)

On extraetf.com and finanzfluss.de you can find these under the investment strategy - dividends.

Which is understandable at first glance, but unfortunately only half the truth.

What you are actually buying here is the quality factor, but this does not appear under Fundamentals / Quality.

What is the quality factor?

The quality factor is part of an investment strategy that selects high-quality companies. The criteria for this factor can be "hard" (e.g. return on equity and free cash flows), but the application of this factor can also be based on "softer" criteria such as the quality of management, corporate governance and market position.

If you want to apply this to an index, you take an investment universe (e.g. the MSCI World) and place one or more filters over it that exclude all stocks that do not meet the criteria.

The remaining stocks can then either be sorted according to market capitalization/balances or other criteria can be added.

Let's take a look at what the target investment objective of the MSCI World Sector Neutral Quality Index is:

"The MSCI World Sector Neutral Quality Index captures large and mid-cap representation across 23 Developed Markets (DM) countries*. The index aims to capture the performance of securities that exhibit stronger quality characteristics relative to their peers within the same GICS® sector by identifying stocks with high quality scores based on three main fundamental variables: high Return-on-Equity (ROE), low leverage and low earnings variability."

In simple terms, this means that as much as possible should flow back to shareholders (through dividends or share buybacks), attention should be paid to sales growth and debt should be low.

These are virtually the prerequisites for sustainable dividend growth.

As all 3 ETFs (Fidelity Global Quality Income, WisdomTree Global Quality Dividend Growth and iShares / Xtrackers MSCI World Quality) invest in shares with similar characteristics and these overlap to some extent, it is no wonder that they also perform very similarly.

https://extraetf.com/de/etf-comparison?products=IE00BYXVGZ48-etf,IE00BP3QZ601-etf,IE00BZ56SW52-etf

It should be mentioned that the WisdomTree Global Quality Dividend Growth differs the most from the other two in terms of its composition. But with 589 stocks, it also holds twice as many stocks as the Global Quality Income or MSCI World Quality. And it also includes momentum screening.

Index Description:

"The index is rules-based, fundamentally weighted and is comprised of high quality dividend[1]paying companies from global developed markets, risk-filtered using a composite risk score ("CRS") screening, which is made up of two factors (quality and momentum), each carrying an equal weighting."

So the WisdomTree Global Quality Dividend Growth is only secondarily a dividend ETF.

It is actually a multi-factor ETF with a dividend filter.

To summarize, what is being done here is simply factor investing with extra steps and you could just as well use the cheaper MSCI World Quality $IS3Q (+0%) / $XDEQ (-0,05%) as well.

Gerd Kommer is proud of you. 😘

Pro tip: there is no MSCI Emerging Markets Quality ETF in Europe, but for the reasons described above you can buy the Fidelity Emerging Markets Quality Income

$FYEQ (-0,1%) as a proxy for the reasons described above.

(Edit: I use this myself $PEH (-0,08%) )

$IS3R (+0,55%) Momentum 0.3TER

$IS3Q (+0%) Quality 0.3TER

$IWVL (+0,3%) Value 0.3TER

$IWDA (+0,23%) World 0.2 TER

According to MSCI, the Momentum and Quality ETFs perform better than the World ETF. The positions are smaller and more concentrated than in the World ETF.

A world option for you?

What do you think?

Since I don't own an ETF and otherwise hold quality stocks, I can well imagine a momentum ETF as an addition.

But I'm not sure whether I would choose one of the ETFs if I only had to bet on a single ETF.

Subsequent purchase

Pensions deposit