Smart Beta ETF vs Customized Factor Portfolios

Reducing the risk of conflicting factor exposures

May 2025. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Smart beta ETFs have multiple factor exposures
  • Combining these in a portfolio leads to factor offsetting
  • Customized stock-based portfolios can reduce such risks

INTRODUCTION

When envisioning the ideal stock portfolio, one might seek stocks that are undervalued yet outperforming, with low volatility. Ideally, these companies would also exhibit strong earnings growth, profitability, and minimal leverage. However, such stocks rarely exist.

In reality, many investment factors are structurally negatively correlated – for example, cheap stocks often lack strong growth prospects. While multi-factor ETFs attempt to screen for these elusive stocks, they often underperform because opposing factor exposures cancel each other out. As a result, investors end up paying high fees for what essentially amounts to broad-market equity exposure (read Factor Exposure Analysis 114: Factor Offsetting).

Rather than spreading focus across too many factors, investors are better off concentrating on one or two. However, even with just two factors, offsetting effects can still arise. As we will demonstrate in this research article, building customized portfolios offers a more effective approach to factor investing than relying on smart beta ETFs.

QUALITY VS LOW VOLATILITY ETFS

Quality and low-volatility stocks are often considered interchangeable when constructing defensive portfolios, but they exhibit distinct characteristics. To illustrate these differences, we conducted a returns-based factor exposure analysis on two of the largest ETFs in their respective categories: the iShares MSCI USA Quality ETF (QUAL) and the Invesco S&P 500 Low Volatility ETF (SPLV).

Our analysis confirms that QUAL, as expected, has a positive beta to the quality factor. However, SPLV surprisingly shows a negative beta to the quality factor, highlighting the fundamental differences between these two investment styles.