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Schwab Enters Smart-Beta ETF Space

NEW YORK ( TheStreet) -- As the exchange-traded fund industry has evolved, one area that has received a lot of attention has been "smart beta."

Smart-beta funds tweak an existing broad-based, market cap-weighted index such as the S&P 500 to target specific stocks. For example, a smart-beta fund might target low-volatility stocks, or high-volatility stocks, or momentum stocks or stocks with certain fundamentals.

The first smart-beta fund was the PowerShares FTSE RAFI US 1000 ETF (PRF), which has been trading for almost eight years.

PRF is a large-cap fund that weights holdings by size, book value, cash flow and dividends. Since its debut, PRF has not outperformed the S&P 500 all of the time, but it has outperformed the benchmark most of the time.

Last week Charles Schwab entered the smart-beta space with the following funds:

Schwab Fundamental US Broad Market Index ETF (FNDB) SYMBOL="FNDB" EXCHANGE="NYSE" PRIMARY="NO"/>

Schwab Fundamental US Large Company Index ETF (FNDX)

Schwab Fundamental US Small Company Index ETF (FNDA)

Schwab Fundamental International Large Company Index ETF (FNDF)

Schwab Fundamental International Small Company Index ETF (FNDC)

Schwab Fundamental Emerging Markets Large Company Index ETF (FNDE)

Schwab has a unique place in the ETF industry. It typically isn't first to market with any type of fund, but it is immediately important in every niche it enters because it offers its ETFs commission-free to its large customer base.

The indices underlying the new Schwab funds were created by Russell Investments based on work done by Rob Arnott at Research Affiliates, the same firm whose research is behind PRF along with many other funds offered by PowerShares.

The Schwab funds will track only three quality factors: retained operating cash flow, adjusted sales and the extent to which a company returns cash to shareholders through dividends or buybacks.

The big question is whether all of this is worth the effort. The answer is a resounding probably. Schwab executive Tony Davidow is quoted in an article at IndexUniverse saying that these funds potentially offer a smoother ride for ivnestors.

Although there can be no absolutes, many of the smart-beta funds perform as expected most of the time.

For example, the PowerShares S&P 500 Low Volatility Portfolio (SPLV) has been less volatile and has outperformed the S&P 500 from its inception up until the last three months. SPLV has 29% in utilities, which are interest rate-sensitive, so the recent Fed taper talk that set off panic in the bond market also adversely affected the utilities sector and, by extension, SPLV.

No smart-beta approach can be the best performer for all market conditions, just as the traditional market cap-weighted SPDR S&P 500 (SPY) cannot be the best performer for all market conditions. As mentioned, SPLV lagged when rates spiked. PRF, by virtue of its ranking process, tends to be heavier in financial stocks than the regular S&P 500 as it was in 2008, and so it went down more than the benchmark during the financial crisis.

These biases are usually easy to spot when looking at a fund's composition, and the new Schwab fundamental ETFs will also have them. The Schwab Fundamental Emerging Markets ETF has a combined 33% in energy and materials, compared with 20% in those sectors for the iShares MSCI Emerging Markets ETF (EEM). This does not make it a bad fund, but if those weightings persist, then at some point it will be a drag on the fund's returns because occasionally resource-related stocks will lag.

The point is not about trying to predict when an oversized exposure to a county or sector will be a problem but to understand what might cause a given fund to struggle. Then you can make a decision about fund that could be overly sensitive to interest rates, such as SPLV.

At the time of publication, Nusbaum had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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SYM TRADE IT LAST %CHG
FNDE $25.62 0.00%
FNDX $30.80 0.00%
FNDF $28.20 0.00%
FNDA $31.10 0.00%
FNDC $28.90 0.00%

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