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Picking the Winners: Focusing on Quality to Deliver a Smarter Smart Beta

Written by: Crystal McClenthen, Sr. Product Manager, Principal Global Investors

It’s not a new concept: try to bet on the winner, hopefully come home with the cash. When talking about investing, Warren Buffett has said it best: “It’s better to buy a wonderful company at a fair price than a fair company at a wonderful price.” The challenge, of course, is twofold. First you must, somehow, find a way to identify “wonderful” companies. Second, you must be able to wisely incorporate those companies into your overall portfolio in a way that not only helps ensure diversification, but also aims to protect your assets in an environment of high market volatility and rising interest rates. But how?

One possible solution is to carefully pick what you believe will be the winners (more on that in a minute!) and build them into a Smart Beta ETF that seeks to provide the ability to gain access to a single risk factor at a lower cost point. And while there are as many strategies out there as there are ETFs, here’s why a strategy designed to pick the winners may be the right route to help your clients achieve the outcomes they’re seeking today—even in this wild ride of a market.

Ever since 2008, investors have been looking for innovative ways to try to tackle the challenge of growing and protecting assets in the face of extreme market swings and a stagnant interest rate environment. It hasn’t been easy, but one strategy that has proven popular has been flowing assets into both dividend yield and minimum volatility solutions. It’s no mystery why this approach has been attractive to investors in recent years, and in many cases it has served its purpose, but rising interest rates may demand a shift in strategy.

To design an ETF strategy that has the potential to perform amid the current changes, it’s important to look at the performance patterns of today’s high dividend solutions to understand how they might react when interest rates begin to normalize. Will the strategy still deliver value? For dividend solutions, which potentially “wonderful” companies have the financial flexibility to sustain their current dividend policies? One approach is to try to develop a better index—one that seeks to provide investors with high income (via dividends) and earnings growth potential (via share repurchase programs)—that may work in a dynamic interest rate environment.

Of course, creating such an index is no easy task, primarily because finding those “wonderful” companies is never as easy as it sounds. But by taking a systematic approach that dissects certain characteristics of each company—and each company’s stock—aiming to pick the winners could possibly become more science than art. More rationale than emotion. Here’s one approach:

First, evaluate each stock according to three key criteria:

  • Is it likely that the stock will sustain its current dividend policy?
  • Does the company appear positioned to maintain margins and earnings in a high interest rate environment?
  • Does the stock offer potential for downside mitigation in an environment of high volatility?
  • If the answer to all three questions is “yes,” next determine if the company is a “price maker” or a “price taker.” What’s the difference? Price makers are companies like Disney [1] . The company’s brand recognition, margins, sales and profitability, quality, and performance are generally solid. But when we’re talking about rising interest rates or the potential for a down market (which, let’s face it, always exists), we believe the most important question is the stock’s elasticity. Will consumers continue to buy when prices rise? When income is down? When there’s a squeeze on spending? In Disney’s case, the answer has historically been a resounding “yes.” Why? Parents are often willing to spend on their children, no matter how much—or how little—cash they have on hand. “Price makers” like Disney tend to grow regardless of the economic environment.

    In contrast, “price takers” exhibit lower brand recognition, margins, sales, profitability, quality, and performance. As a result, their prices are often dictated by the rest of the market, and they typically have less elasticity when it comes to unfavorable market conditions. While their prices may rise over time, they may not offer the level of performance required to be a reliable market winner.

    This is precisely the approach our team at Principal took when building our new ETF that tracks an index in Nasdaq’s smart beta suite: the Nasdaq Price Setters Index ETF (PSET). The fund looks to invest in large- and mid-cap US companies that we would classify as “price setters” and we expect would exhibit the following favorable characteristics as compared to the S&P 500 Index. The index the ETF is designed to follow, the Nasdaq US Price Setters Index, selects its components from the Nasdaq US Large Mid Cap Index. And while PSET is a new fund (it was launched on the Nasdaq Stock Exchange on March 21 st ), the Nasdaq US Price Setters Index seeks to identify securities that not only possess sustainable pricing power, but also are expected to display quality financial metrics.

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    Building a “smarter” Smart Beta is all about making choices that seek to address today’s changing environment. It’s all about striving to pick the winners. While not even Warren Buffett can pick every winner every time, this approach could be a good way to try to identify “wonderful” companies that have the potential to deliver the exposure your clients are seeking today—all leveraging the innovative capabilities of a Smart Beta ETF.

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    Carefully consider a fund’s objectives, risks, charges, and expenses. For a prospectus, or summary prospectus if available, containing this and other information, visit PrincipalETFs.com or call Sales Support at 800-787-1621. Please read it carefully before investing.

    The Fund seeks to provide investment results that closely correspond, before expenses, to the performance of the Nasdaq U.S. Price Setters Index.

    RISKS Asset allocation and diversification do not ensure a profit or protect against a loss. Investing in ETFs involves risk, including possible loss of principal. ETFs are subject to risk similar to those of stocks, including those regarding short-selling and margin account maintenance. Equity investments involve greater risk, including heightened volatility, than fixed-income investments. Past performance does not guarantee future results.

    This Fund is new and has limited operating history. ETFs can be tax efficient in that they are exchange-traded and redeem creation units from authorized participants by using redemptions in kind, which are not taxable transactions for the Fund. However, capital gains are still possible in an ETF, and if you reinvest the earnings of the ETF, you may owe taxes on your funds even if you didn’t sell any shares, potentially eating into your returns. Investor shares are bought and sold at market price (not NAV) and are not individually redeemed from the Fund. Ordinary brokerage commissions apply.

    ALPS Distributors, Inc. is the distributor of the Principal Price Setters Index ETF. ALPS Distributors, Inc. and the Principal Funds are not affiliated.

    [1] As of 06/09/2016, the Principal Price Setters Index ETF held 0.94 % of Disney.

    Read more from Nasdaq Global Indexes at www.busines.nasdaq.com/nasdaq-index-insights.