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Client Conversations: A "Smart" Way to Index in Your Portfolio

March 2018

The expected investment landscape ahead may look a lot different than it has in recent years.

Client Conversations gives financial advisors an easy way to communicate with clients on topics influencing financial markets; it highlights common investor behaviors and offers ways to address the challenges investors face. Share this article with your clients, and remember to follow your firm's policies that govern sharing content with clients and prospects.

Investors using traditional means of investing could soon face a number of difficulties in their search for returns.


A hidden risk

Traditional market-cap-weighted exchange-traded funds (ETFs) are designed to mirror a benchmark of stocks, bonds, or other asset classes. For example, the S&P 500 Index is a well-known market-cap index.1 If the S&P 500 Index goes up or down, a market-cap weighted ETF would generally do the same. Fortunately for investors, the S&P 500 Index has performed well since the Great Recession ended. However, this strong performance masks the potential danger of less-generous returns going forward for investments that seek to track an index.

As the name suggests, market-cap indices are weighted by the size of companies within the index—the largest companies in the index get the largest allocation. When you invest in a market-cap-weighted ETF, most of your money is concentrated in the biggest companies by design (FIGURE 1). By contrast, a newer investment concept, strategic beta (or smart beta),2 has the ability to address this hidden risk.


Figure 1

More Than 21% of the S&P 500 Index Is Concentrated in Top 10 Stocks


Source: Morningstar; As of 12/31/17; For Illustrative purposes only


Certificates of Deposit (CDs) are short-term investments that pay fixed principal and interest, are insured by the FDIC up to $250,000, and are subject to changing renewal rates and early withdrawal penalties. The tax rate used in the example is the highest marginal federal income tax rate based on $100,000 of taxable income for a married couple filing jointly. The tax rate is not representative of the experience of every investor, and a lower tax rate would have a favorable effect on the real return. 


A new strategy

Strategic beta strategies have been used by institutional investors for years. Today, they account for $1 trillion in worldwide assets.3 Only recently have they become more widely used by individual investors and are often available as ETFs.
Rather than tracking existing stock or bond indices like market-cap-weighted strategies do, strategic beta strategies seek to mirror a custom-built index of stocks that represent an alternative (or “strategic”) approach to the market. These strategies may seek to improve diversification and/or focus on a particular subset of stocks within the market to help improve risk and return potential. Often they seek companies with favorable investment characteristics called factors.

A factor is the name for a stock’s characteristics or attributes. That may include statistical measures indicating its value, small size, quality, or recent performance behavior, such as momentum and low volatility. Ultimately, factors can drive a stock’s risk and return potential.


How strategic beta works

Suppose your portfolio needs greater diversification than a traditional US market-cap-weighted index can provide. You may want to invest in a strategic beta ETF focused on US stocks. It would seek to track a specialized index tracking US companies and be strategically designed to help improve risk and performance potential. These strategies rely on a set of rules that drive portfolio construction—an approach that is designed to provide consistency, transparency, and outperformance potential, often at a lower cost.

FIGURE 2 shows that factors rotate in and out of favor over time. Using multiple factors (i.e., a multifactor approach) may help increase diversification, reduce volatility, and provide the potential for better returns relative to a market-cap-weighted approach.



Factors Can Be Another Source of Diversification

Excess factor returns* of US factor-based hypothetical portfolios (1/1/08-12/31/17)


*Excess factor returns are factor returns after subtracting market beta. Market beta is the returns of a market index and is represented by the MSCI USA Index. Market beta is represented by the MSCI USA Index. The chart ranks the performance of various factor-based hypothetical portfolios using the US universe as defined by Hartford Funds. Portfolios were rebalanced monthly. From the date of each rebalance, to be included in the universe, a stock must have had an average daily trading volume over the last 6 months > $1.5 million and a total market capitalization > $500 million, resulting in a universe of approximately 2,500 stocks. Value, Momentum, Quality, Small Size, and Low Volatility represent factor-based portfolios that select the companies in the first quintile when ranked from highest to lowest score based on each respective factor, and equal-weights them. The portfolios are theoretical and assume no fees or trading costs. Actual results may differ significantly.

Performance is based on annual “total returns,” which includes reinvested dividends but not interest, capital gains, taxes or transaction costs. Data Sources: Compustat and MSCI. Calculations by Hartford Funds. For illustrative purposes only. Results are subject to change. MSCI USA Index is designed to measure the performance of the large- and mid-cap segments of the US market. MSCI performance is shown gross of dividend withholding tax. Annual Returns for MSCI USA Index are shown from 2008 to 2017. Indices are unmanaged and not available for direct investment. Past performance is no guarantee of future results.


Implementing a strategic beta strategy

Strategic beta strategies can empower investors with diversification and forward-looking exposure. Talk with your advisor to discover how adding products with strategic beta strategies and a multifactor approach to your portfolio can help you potentially find capital growth in what could be a challenging investment landscape in the years ahead.


Client Conversations gives financial advisors an easy way to communicate with clients on topics influencing financial markets; it highlights common investor behaviors and offers ways to address the challenges investors face. Share this article with your clients, and remember to follow your firm's policies that govern sharing content with clients and prospects.

1 S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks. The index is unmanaged and not available for direct investment.
2 Strategic beta and smart beta refer to investment strategies that emphasize the use of alternative weighting schemes to traditional market capitalization-based indexes.
3 Data Source: Morningstar, 12/17
4 MSCI USA Index is designed to measure the performance of the large- and mid-cap segments of the US market.


The MSCI information may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not beused as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice ora recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken asanindication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties or originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shallany MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (

This information should not be considered investment advice or a recommendation to buy/sell any security or to participate in any investment strategy. In addition, it does not take into account the specific investment objectives, tax and financial condition of any specific person. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. This material and/or its contents are current at the time of writing and are subject to change without notice. This material may not be copied, photocopied or duplicated in any form or distributed in whole or in part, for any purpose, without the express written consent of Hartford Funds.

Exchange-traded products are distributed by ALPS Distributors, Inc. (ALPS). Advisory services are provided by Hartford Funds Management Company, LLC (HFMC) and its wholly owned subsidiary, Lattice Strategies, LLC (Lattice). Hartford Funds refers to Hartford Funds Distributors, LLC, Member FINRA, HFMC, and Lattice, which are not affiliated with ALPS.

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