Salt Financial, a start-up ETF issuer based in New York, recently unveiled the Salt truBeta High Exposure ETF (SLT US) on Cboe Global Markets. SLT targets companies expected to exhibit higher volatility relative to the broad US market using the firm’s so-called “truBeta” process.

Tony Barchetto, founder and chief investment officer, Salt Financial.

Beta, a measure of the volatility of a security (or portfolio) in comparison to the market as a whole, is just one of many measures available to gauge the risk of a portfolio.

While it has deep roots in early portfolio theory and the Capital Asset Pricing Model (CAPM), Salt Financial believes that plain old beta has been overshadowed by the many flavors of smart beta available to investors. While smart beta gets all the attention, the firms notes that original market beta still explains about 70% of the variation in returns in your average diversified equity portfolio.

Targeting higher beta as an investment strategy however has posted mixed results. The S&P 500 High Beta Index, which consists of the 100 highest beta components of the S&P 500, has lagged the S&P 500 over the long term, returning 3.7% on a total return basis compared to 6.4% from April 1998 through April 2018. This is where Salt Financial aims to make a difference.

The proprietary truBeta process seeks to more accurately forecast a stock’s sensitivity to market movements, compared to traditional measures of beta. By doing so, the firm plans to deliver portfolio construction tools that provide magnified exposure, without the use of risky derivatives or expensive borrowing.

James Lord, consultant analyst and writer for ETF Strategy caught up with Tony Barchetto, founder and chief investment officer at Salt Financial to look under the hood at the engine driving the firm’s debut ETF.

JL: What is the difference between traditional beta and truBeta?
TB: The traditional ways of calculating beta have a problem—stale numbers. The most common method of calculating beta uses five years of monthly returns to estimate how a stock or portfolio is likely to move with the market. A lot can happen in the market and to a company over the course of five years. As a result, it can take a long time for more recent changes in stock behavior to be reflected in beta, making it less effective a tool to gauging market risk in the near-term.

Using more recent data to forecast how a stock will move with the market can address the problem of stagnant calculations and provide a more accurate view of forward beta. Salt Financial’s truBeta combines the more traditional longer term historical data with more recent intraday returns over the past two months to generate a forecast of beta over the next quarter that is designed to be more responsive and timely.

JL: How has Salt Financial harnessed the truBeta process to deliver an investible strategy for clients?
TB: truBeta estimates form the heart of the Salt truBeta High Exposure Index. Designed to provide magnified exposure to US equities, the index utilizes the responsiveness of truBeta to target stocks likely to be more sensitive to market movements. The selection process begins with the top 1000 US stocks by market capitalization, filters the top 500 by trading volume, and then eliminates stocks with a weaker relationship to broad market moves. From this minimum of 250 remaining liquid stocks, the 100 stocks with the highest truBeta score form the index, which is equally weighted and rebalanced quarterly. Sector exposure is limited to 30 components, keeping the index more aligned with the broader market, yet common overweighted in financials, technology, industrial, materials, and energy form quarter to quarter.

The result is an index that aims to mimic the effects of leverage without the use of borrowing or derivatives. It purposefully increases volatility but seeks to capture higher returns to compensate the investor for bearing the risk.

JL: Why would an investor want additional volatility?
TB: There’s a place in many portfolios for higher growth, higher risk investments, especially for investors in the accumulation phase of their lives with many years until retirement. An allocation to growth funds, technology stocks, and other traditionally riskier investments can pay off in the long run in a diversified portfolio with more time to recover from potential draw-downs in the near-term.

Secondly, volatility can be “harvested” by investors over time through periodic rebalancing. According to an analysis done by Morgan Stanley of a standard 60/40 portfolio (S&P 500/Barclays Bloomberg Aggregate Bond Index) from 1977-2014, simple rebalancing added 35 basis points of return per year, which boosted portfolio value by an additional 12.6% by the end of the period. Some volatility is required to capture any gains from rebalancing, allowing investors to turn a negative effect into a positive with some discipline.

Adding some higher volatility investments to the mix can potentially enhance returns and increase the benefits from rebalancing, provided they can recover from the inevitable drawdowns. While an entire portfolio of higher risk investments is likely to be inappropriate for any investor, a smaller allocation to a more aggressive strategy can be beneficial for investors with an appetite and time horizon to assume additional risk is search of higher returns.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)