Chief Investment Officer

3D Asset Management


Note: an edited version of this article first appeared on

A lot has been written about the strong market performance in 2017, but not much has been written about the impact of the wide U.S. sector dispersion on U.S. smart beta performance.  When most equity strategies returned north of 20%, one doesn’t necessarily quibble about dispersion or relative performance amongst like-minded strategies. 

We’ve published several articles on concerning the importance of understanding how one’s smart beta ETF is constructed and how it fits within the overall portfolio.  Smart beta ETFs that deliver single factor exposure (i.e. value, momentum) will generally deliver similar results to each other as the underlying factor volatility will drive the overall volatility of the ETF over the long run.  However, differences in basket design and security weightings can produce material short-term dispersion amongst similar strategies, which further amplifies the importance of understanding how these ETFs fit within your overall portfolio from a risk contribution standpoint. 

In the past, we’ve highlighted key differences within the low volatility smart ETF category using iShares MSCI USA Minimum Volatility (USMV) and PowerShares S&P 500 Low Volatility (SPLV) as two primary examples.  The former delivers a low volatility portfolio via risk-based optimization while the latter delivers a portfolio of low volatility stocks via ranking and weighting the lowest volatility stocks within the S&P 500.  Over the long run, such differences should smooth out, but they can lead to short-term dispersion. 

In 2017, technology stocks dominated all the other S&P sectors (Figure 1).  We’ve written about how sector positioning around technology can explain a large portion of the outperformance active managers enjoyed last year (especially large value managers versus a market-cap weighted style benchmark like the Russell 1000 Value Index).  This high level of sector dispersion was a main contributor to the dispersion seen amongst smart beta ETFs that provide exposures to the same factor theme. 

Figure 1 – Technology Sector Dominated All Other Sectors in 2017


In factor construction, one determines whether to ‘neutralize’ sector effects or not.  This can be done at the ranking stage (where stocks are ranked within their respective sectors) or at the portfolio construction phase (where sectors are assigned their market cap weighting; larger sectors receive larger overall weightings). 

In 2017, sector neutralization largely determined how your smart beta ETF performed and whether it delivered the ‘desired’ factor exposure you were expecting.  A momentum smart beta ETF that didn’t sector neutralize probably performed well above momentum ETFs that incorporated some form of sector neutralization (Figure 2).  For instance, the MSCI Momentum Index methodology (the tracking index for iShares USA Momentum ETF (MTUM), does not apply sector neutralization when constructing the factor index, although it does take into account the security’s market capitalization in the final index weighting which can help temper the overall sector exposures. 

Figure 2 – 2017 Calendar Year Returns of Representative Single Factor Momentum ETFs versus S&P 500 ETF (SPY)


However, some smart beta ETFs perform sector neutralization so as to minimize the risk contribution from sector over / underweighting versus a market cap-weighted benchmark like the S&P 500.  Figure 3 displays the technology weightings of representative momentum smart beta ETFs.  Although it is not a one-to-one relationship, better performing momentum ETFs generally had higher technology weightings. 

Figure 3 – Latest Reported Technology % Weighting of Representative Single Factor Momentum ETFs versus S&P 500 ETF (SPY)


For value-based smart beta ETFs, the opposite happened: value-based ETFs that sector neutralized generally outperformed those that didn’t (i.e. the Russell 1000 Value Index).  Figure 4 displays the 2017 calendar year returns of representative single factor value-based ETFs versus the S&P 500 ETF (SPY).  Figure 5 displays the technology sector weighting.  The performance dispersion is even more striking with the traditional style-based ETFs that track the Russell 1000 Value Index and S&P 500 Value Index underperforming value-based ETFs that sector neutralize such as VLUE and FVAL. 

Figure 4 – 2017 Calendar Year Returns of Representative Single Factor Value ETFs versus S&P 500 ETF (SPY)


Figure 5 – Latest Reported Technology % Weighting of Representative Single Factor Value ETFs versus S&P 500 ETF (SPY)

To Neutralize or Not Neutralize – That is the Question (At Least for 2017)

Over time, the differences associated with sector neutralization should wash out as one would expect the underlying factor variance to explain most of the overall ETF variance.  However, 2017 highlights how wide (and lopsided) sector dispersion can lead to smart beta ETF dispersion. 

So, what is the right approach when constructing smart beta ETFs?  If you look underneath the hood of most tactical sector rotation strategies, they’re generally incorporating some form of momentum or trend following signals.  Rarely will you ever see them incorporate valuation-based signals.  That is because momentum, rather than valuation, tends to be a better predictor of forward relative returns.  That is one of the reasons why the research team at MSCI neutralizes the sector exposure in their Enhanced Value Index but not in the Momentum Index. 

Factor purists would argue that one should invest in the factor itself, regardless of the resulting sector or ancillary risk exposures.  You take the bad with the good because it all helps explain the historical factor behavior.  It’s when you start introducing neutralization and optimization techniques to stamp out the ‘unwanted’ external factor sources that you lose the purity of the underlying factor. 

Regardless, the sector dispersion of 2017 highlights the importance of knowing what you’re investing in.  Sector neutralization might make sense if you hold a portfolio with few positions and you desire the underlying sector exposures to reflect the broader market.  Non-neutralization might make sense if you are targeting purer factor exposures or you want to offset the sector bets taken in other parts of the portfolio.  It comes down to portfolio construction and how the smart beta ETF fits within your overall portfolio.

At the time of this writing, 3D Asset Management held positions in USMV, SPLV, VTV, and MTUM.  The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of February 6, 2018, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing or visiting 3D’s website