ETF Expert Corner

PowerShares’ John Feyerer Goes In-Depth on Smart Beta ETFs

March 28th, 2017 by ETF Store Staff

John Feyerer, V.P. Equity ETF Product Strategy at PowerShares, goes in-depth on smart beta, including spotlighting several popular PowerShares ETFs.



Transcript

You can listen to our interview with John Feyerer by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: I'm now very pleased to welcome to the program John Feyerer, Vice President of Equity ETF Product Strategy at PowerShares. PowerShares is currently the fourth largest ETF provider in the country. They offer nearly 150 ETFs with some 120 billion dollars in assets. While PowerShares offers a wide range of ETFs, they're probably best known for being a pioneer in the smart beta ETF space, which is what we'll focus on today. John, great to have you back on the program.

John Feyerer: It's great to be here. Thanks for having me.

Nate Geraci: John, first of all, before we get into some of the smart beta ETFs that PowerShares offers, I'm interested in hearing your definition of smart beta, because this is a term that gets tossed around quite a bit. Some like the term smart beta, some hate it. How does PowerShares define smart beta?

John Feyerer: You know, I agree with you on the term. I do think that often we have, as we talk about the concept that underlies smart beta, the term in some regard sometimes gets in the way of, I think, a productive discussion about how the paradigm in which we invest in markets has changed, and is really, I think, changing before our eyes, if you will. If you look at it historically, investors have really thought of two different kind of approaches to investing. Either active, where you're employing a manager to go ahead and go out and select securities in an effort to outperform the market, or obviously buying the market in terms of investing in market capitalization weighted benchmarks. What smart beta does is really kind of situate itself in between those two traditional approaches to investing. Smart beta actually tends to retain the attributes of traditional benchmark investing in that it's based upon rules-based indexes, methodologies that are set up and established beforehand that follow very explicit rules when it comes to selecting securities, weighting securities when the methodology re-balances. So it does tend to retain those attributes of traditional passive investing while having an objective that it's going to vary in some cases, but is generally looking to enhance risk adjusted returns for a given approach relative to a passive benchmark. So a couple of key ingredients that we look at when it comes to smart beta is really understanding the methodology on which the strategy is based. Is it 100% rules based? Is it transparent? Is it simple? Is it easy to understand? Does it rebalance on specified dates? As I just said, is the process, I guess, purely mechanical you could say? Secondly, in terms of an attribute, we also look for strategies that do not use market capitalization to weight the constituents. I mean, the traditional approach to indexing the S&P 500, the Russell 1000, those indexes that we look at every day, those are weighted based upon market capitalization, which takes current share price, multiplies it by shares outstanding, and then that helps you arrive at the relative size of a company. Smart beta strategies do not use market capitalization. They'll use other approaches such as something as simple as equal weighting, or weighting based upon factors such as low volatility or quality and the like. Then, the last element that I would just really emphasize as very important when it comes to recognizing a smart beta strategy is that the rebalancing mechanism is disciplined. As I said earlier, it's set in time in terms of the frequency and the date. Regardless of what's going on in the market, if you will, it really is just going to follow those rules and rebalance according to the weight of the strategy we set out and the way that the index is put together. So very rules-based, very formulaic, and very objective in its approach. That's really, when you look at it, once again, smart beta. We see it kind of situating between traditional passive and how investors would traditionally view active strategies.

Nate Geraci: John, just at a high level, is the rationale for investing in smart beta simply the potential for better risk adjusted returns?

John Feyerer: That's certainly one element, but when you look at it, we see smart beta strategies as really serving a few different purposes. Enhancing risk adjusted returns is certainly one of the attributes. Another is simply just risk management. We offer, as an example, low volatility strategies that enable investors to maintain equity investments in the market, but do so through strategies that have demonstrated lower volatility and, therefore, it can be used as a tool to help reduce risk within a portfolio. Then, the other element is really diversification. A lot of times when you reduce an investor's portfolio to the factor exposures that it has, one of the elements that a smart beta strategy can help introduce is exposure to a given factor. Now, low volatility is another example of just a way to diversify the overall investment portfolio. So the risk adjusted returns, enhancing risk adjusted returns is one of the elements, and certainly one of those that is probably most talked about. But there's certainly the element of just being able to better help investors manage risk within their portfolio, and then also enhance overall diversification.

Nate Geraci: Again, we're visiting with John Feyerer, Vice President of Equity ETF Product Strategy at PowerShares. We're talking smart beta ETFs today. John, let's walk through a few PowerShares smart beta ETFs, because I think that may be the best way to sort of help crystallize these strategies for listeners. You mentioned low volatility. Currently, one of the most popular smart beta ETFs at PowerShares is the PowerShares S&P 500 Low Volatility ETF, ticker symbol SPLV. This owns the 100 least volatile stocks in the S&P 500. Tell us a little bit more about this ETF and perhaps the rationale for owning it in an investment portfolio.

John Feyerer: We're really excited about this. This is a strategy that we actually partnered with S&P Dow Jones back in 2011 to bring the very first low volatility ETF to market. As you said, it's a very simple, transparent, easy to understand methodology. What the index does, simply, is it takes a look on a quarterly basis at the 500 stocks within the S&P 500 and actually sorts them based upon their realized volatility, from least volatile to most volatile, on a trailing, one year look back. So again, each quarter, it's going to take kind of a backward looking snapshot in time, and force rank those stocks within the S&P 500 based upon their realized 250-day trailing daily volatility, and then simply, as you said, take the 100 stocks that have exhibited the least volatility over that time. And what we've seen, and once again, we have a live track record with this particular strategy, this is actually coming up on six years now, and we've seen that approach really being successful for investors in terms of mitigating downside, while still enabling them to participate in the market. The way we talk about low vol is very simply the two P's. What do I mean by that? Potential protection in terms of downside mitigation, as well as participation in terms of having equity market participation. One of the key elements, or key metrics I should say, that we regularly look at is in terms of the investor experience what we call kind of the up down capture ratio. Up capture versus down capture, and over long periods of time, how much of the market's upward movements does the strategy such as SPLV capture versus that which it participates to the downside? What we see is usually about 80 to 85% of the market's upward movement and about 50%, 45 to 50% of the market's downward movement. So it really tends to benefit investors in terms of the downside protection. When markets are drawing down, strategies such as SPLV has demonstrated that it draws down, in some cases, significantly less than the market, and thus can be a very effective holding within an investment portfolio.

Jason Lank: John, this is Jason Lank. Welcome back to the show. I want to stay with low vol for a moment. You mentioned that there are potentially some risk management characteristics that investors might find attractive, but as an advisor, I try to look at all the angles and potential downsides too. Low vol has received a lot of attention in the press, and with that comes capital flows. You guys have been probably happy recipients of some of that. Is there ever a position or a time when the low vol strategy still holds, but valuations are elevated, perhaps mitigating that? Are there any downsides to this strategy?

John Feyerer: Well certainly, like any strategy, it has the potential for downside and even during the live track record have seen instances where we've seen a draw down over a certain period of time where low vol has participated in that to the extent that the market has, and in some cases even more. But in general, and quite often, and as I said, you just look at the long term up down capture ratio, we think it's a pretty telling statistic in terms of how the strategy can help mitigate down drafts and participate in markets. But to your point, or to your question, there certainly has been some questions and some discussions surrounding valuations and low volatility. To your point, we've seen flows in the space that are between our product as well as a few others within the ETF space that's seen significant flows over the last couple of years. But a couple of things to keep in mind with that is that when you take a look at the amount of money that has come into low volatility relative to the overall amount of money invested in these segments of the market, it's still very, very, very small. I mean, you can measure market capitalization of the S&P 500 in the trillions of dollars. And we're talking about billions in terms of just, like I said, our strategy - I want to say is about 7 billion dollars right now. So still very small relative to the overall market. The other thing that I would mention that we've studied quite a bit is taking a look at how current valuation has historically impacted subsequent performance. And what we have seen is that the biggest driver of relative return, by that I mean return of a low volatility strategy versus that of the parent benchmark, in this case the S&P 500, the much bigger driver has been the market environment that has really been experienced during that time. I mean, typically if you look at a low volatility strategy, regardless of where the starting valuation is, if you look at it in a market environment in which there's strong double digit returns and a very strong bull market, in most cases, in the vast majority of cases, low volatility is going to lag a traditional benchmark index. But if you flip that and you say, "You know, in a subsequent market environment, that's a little tougher sledding, if you will. And markets are either in very low return environments, or in some cases, negative return environments, that's when low volatility tends to really shine." So the work that we've done, along with the folks at S&P, studying valuation as a tool for gauging when to enter and exit a strategy such as low volatility, we see this is not a very useful gauge when it comes to really what the factor of a low volatility factor can do for a portfolio. The much bigger determinant is really what is the market environment. As I said, if it's a strong bull market, you're likely going to see low volatility underperform, and in some cases, underperform by a decent clip. In other instances, like I said, if there's draw down or a very low return environment on those rougher seas, if you will, that's when low volatility tends to really shine for investment portfolios.

Nate Geraci: Our guest today is John Feyerer, Vice President of Equity ETF Product Strategy at PowerShares. John, another PowerShares ETF that looks to take advantage of low volatility is the PowerShares High Dividend Low Volatility ETF, ticker symbol SPHD. I'm curious, how does this compare to SPLV?

John Feyerer: This is a strategy that we introduced, once again, partnering with the team at S&P Dow Jones back in October of 2012. This is really a strategy that incorporates two factors, if you will. First and foremost, it's a yield or an income-oriented strategy. What it's doing here is, once again, starting with the S&P 500, the 500 stocks within that index, and on a trailing 12 month basis, it's simply sorting the stocks within the index and taking the 75 highest yielders. So it's initially a focus, in terms of the initial universe, on those stocks that have the highest yield over that trailing 12-month time horizon. But then, before the final portfolio is arrived at, it actually takes a look at volatility, and then will screen out the 25 relatively higher volatility stocks, ultimately arriving at a 50 stock portfolio. So it's really a two-step process. First, focus on income and yield, but then adding that element or that overlay, if you will, of volatility. With SPLV, the only approach to constructing the index that S&P uses is trailing 250-day volatility. In this instance, it's looking first at income, but then as a secondary screen, incorporating the concept of low vol. Really, what we see that as being a potential benefit for investors is really, when you look at ... Obviously, if a company's dividend is high, so high that it ends up in a dividend or yield-oriented portfolio, in some cases it's there because it's a strong dividend paying stock. In other cases, it may be because that individual stock price is potentially depressed. What this strategy really does is by incorporating that volatility screen, it will remove a lot of those companies that have demonstrated the higher volatility. So we've seen investors really utilize this strategy as an income-oriented strategy within the equity sleeve of their portfolio. As I said, when you combine those two factors, pretty powerful. When you look at the up capture down capture that we've seen with the strategy since it went live in October of 2012, I want to say it's about 95% of the market's upside participation, and about 55 to 60% of the market's downside. Once again, a positive up down capture ratio, if you will. But really the difference with SPHD is the emphasis on income, and then screening for volatility.

Nate Geraci: Alright, quickly here, I did want to ask you about the PowerShares S&P 500 Quality Portfolio, ticker symbol SPHQ. I think just given the current environment, quality is something investors are certainly paying more attention to. Tell us a little bit about this ETF and where it may fit in an investor's portfolio.

John Feyerer: Now, this is another one, another factor that we see is a very useful tool, if you will, within the overall investor toolkit. This particular strategy, once again, starts with the stocks of the S&P 500, and then on a twice annual basis, what it does is sort the stocks based upon quality measures such as debt to equity, really measuring the financial health of a company. Or, return on equity, measuring the income generation of a particular company. There's also an earnings quality metric that is utilized. Those three metrics come together to really help assign scores across the full universe of S&P 500 stocks. Then, similar to SPLV, what it will do is take the 100 stocks that have scored the best based upon these quality metrics and that forms the S&P 500 quality portfolio, SPHQ. Really, we see this in particular, as you all just mentioned, we've seen how far this market has come, and we just see, whether it's strategies such as low vol, high dividend low vol, or in this case, high quality, really being able to serve as the core or a portion of the core of an investment portfolio because they are doing the job of essentially addressing the, in this case of SPHQ, really looking at identifying those companies that have the highest quality attributes in terms of, as I said, ability to generate income in terms of return on equity, having strong financial balance sheets as measured by the debt to equity ratio. Then also, as I said, having strong earnings quality as well. So this strategy, SPHQ, really enables investors to access those companies in an ETF. And really, this strategy, we feel like can serve as a long-term core for an investment portfolio.

Nate Geraci: John, we have about two minutes left here. I thought you did a great job of walking through those three ETFs, but before we let you go, as you know, there are a lot of different smart beta ETFs currently available on the market and it seems like the list of these ETFs grows by the day. Just high level, how do you think investors should go about sifting through the different options out there? Because I do think it can be a bit overwhelming.

John Feyerer: No question it can be. It's amazing. You know, PowerShares was a pioneer in this space, now what, 13, 14 years ago. We have just seen the space explode with different offerings, and just frankly, the complexity has grown immensely as well. One of the things that I really like to focus on with folks that we talk to is just really looking at simplicity and transparency. I mean, asking yourself, "Hey, you know, I understand how this particular methodology comes together, and if it takes you more than, 30 seconds to a minute to just map through a methodology and being able to understand, oh okay, it's the 500 stocks of the S&P 500. They're measuring based upon, the daily price movement and then just simply taking those that have exhibited lower price movements." Fairly simple to understand. There's not a lot of complexity there. We feel like that simplicity and that transparency is just one of the key elements that investors should really look at. The other quick things I would mention would be just the length of track record. So often, we see new entrants coming into the market on a very regular basis in which they're publishing, or they may be talking about a certain track record, and then that goes back. But when we look at the live track record, we see it's only in some cases months or weeks old. Having a demonstrated track record that is upwards of 10 to 15 years we think is something that's really important, being able to evaluate how did the strategy perform different during different market environments. Those types of things are critical to be able to understand. It's once again the simplicity, the transparency, the length of track record. Then, the last thing I would mention is just really the index provider, because one of the things that we do at PowerShares is really look to work with very reputable index providers such as S&P Dow Jones, FTSE Russell, the NASDAQ, and so on and so forth. Definitely having strong names and firms that can help educate on these various strategies is critical as well. Those are some of the things I would look at when it comes to evaluating, as you said, a very busy marketplace in smart beta.

Nate Geraci: John, I think excellent advice. We will have to leave it there. Great having you back on the program today. As always, we appreciate your time. Thank you.

John Feyerer: Certainly. Great to be back with you guys. Thanks so much.

Nate Geraci: That was John Feyerer, Vice President of Equity ETF Product Strategy at PowerShares. You can learn more about the PowerShares ETF lineup by visiting PowerShares.com.