A Trio of Smart Beta ETF Strategies

04/25/2017 2:50 am EST

Focus: STRATEGIES

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

The advent of smart beta strategies has unleashed an explosion of financial innovation as analysts translate different strategies into different indexes. Some of these strategies work better than others, explains Nicholas Vardy, editor of The Global Guru.

To start, I recommend you stick with the most basic “smart beta” strategies: those that invest in stocks included in the S&P 500.

1. ‘Smart Beta’ Strategy #1 -- S&P 500 Equal Weight Index

A traditional S&P 500 Index Fund, such as the SPDR S&P 500 ETF (SPY), weights stocks according to market capitalization. This means that the more valuable a stock is, the bigger its weight in the index.

In SPY's case, the top 10 holdings currently account for 18.52% of the portfolio and include mega-cap stocks like Apple (AAPL), Microsoft (MSFT) and Amazon (AMZN).

By contrast, the S&P 500 Equal Weight Index weighs each S&P 500 component equally and rebalances holdings quarterly.

Note that both strategies hold the same stocks. Only the position sizing strategy differs. Various studies have shown that the equally weighted S&P 500 Index outperforms the traditional S&P 500 by over 2% per year going back to 1966.

Today, you can invest in the equally weighted strategy through the Guggenheim S&P 500 Equal Weight ETF (RSP), rated four stars by Morningstar.

RSP’s 10.4% annual return since its inception in 2003 beats the 8.1% return for the S&P 500 over the same period. This includes the drag of RSP’s annual expenses of 0.40%.

2. ‘Smart Beta’ Strategy #2 -- Dividend Aristocrats

The Dividend Aristocrats are the S&P 500 companies that have increased dividend payments for at least 25 consecutive years.

Today, 51 stocks meet this requirement. They include household names like AT&T (T), Johnson & Johnson (JNJ) and Abbott Laboratories (ABT).

According to S&P Research, the Dividend Aristocrats generated an annualized return of 9.7% over the past 10 years. That easily tops the S&P 500’s return of 6.3%. The chart below shows their performance between 1990 and 2014.

The Dividend Aristocrat Index’s annualized returns are also much steadier than the overall S&P 500. Most notably, in 2008, the Dividend Aristocrats dropped 22%, while the S&P 500 collapsed 37%.

So, investing in Dividend Aristocrats both boosts your returns and historically has offered better downside protection. That’s just about the closest thing you can get to a ‘Holy Grail’ of investing.

You can invest in Dividend Aristocrats through the ProShares S&P 500 Dividend Aristocrats ETF (NOBL). It is rated five stars by Morningstar.

For income-oriented investors, the fund’s 2.02% yield beats the S&P 500 Index’s yield of 1.92%. It has an expense ratio of 0.35%.

III. ‘Smart Beta’ Strategy #3 -- Dividend Dogs

The “Dividend Dogs” strategy is a close cousin of the “Dogs of the Dow” theory, popularized by Michael O'Higgins in his book, Beating the Dow.

The Dogs of the Dow are the 10 of the 30 companies in the Dow Jones Industrial Average that have the highest dividend yield.

Between 1957 and 2003, the original “Dogs” outperformed the Dow by about 3% per year, averaging a return of 14.3% annually, whereas the Dow Jones averaged 11%.

Enter the ALPS Sector Dividend Dogs ETF (SDOG), which expands the “Dogs of the Dow” theory to the S&P 500.

Specifically, SDOG invests in the five highest-yielding securities in each of the 10 sectors of the market, generating a concentrated portfolio of 50 stocks.

The rationale for this approach is clear. The higher-yielding shares in the S&P 500 are expected to bring their yields in line with the market. In doing so, they outperform the broader market.

The ALPS Sector Dividend Dogs Index has outperformed the S&P 500 by 2.84% per year since its inception in July 2012. The ALPS S&P Sector Dividend Dogs ETF is rated five stars by Morningstar.

For income-oriented investors, the fund’s 3.31% yield beats the S&P 500 index’s yield of 1.94%. SDOG charges 0.40% in annual fees.

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