The Next Smart Beta Revolution

{Note: This post was an April Fool’s joke!]

As the ETF industry in Canada matures, more and more providers are moving away from traditional cap-weighted index funds in favour of more exotic strategies, which have been lumped together under the label smart beta. The goal is to build indexes that will deliver excess returns by adding more exposure to stocks with specific characteristics, known as factors.

For example, small cap stocks in the U.S. beat the S&P 500 by almost 2% a year from 1926 through 2012  (the size factor), while stocks with a low price-to-book ratio outperformed by a similar amount (the value factor). More recent evidence has revealed other factors, such as momentum and profitability. Now a group of academics has discovered a way to combine all of these factors into a single strategy that will revolutionize the way we invest.

The researchers have not yet published their findings, but I recently had a chance to interview the group’s leader, Dr. Molti Fattore, professor of financial engineering at the University of Milan. “It’s really very simple,” he explains. “We’ve known for a long time that the various factors can boost returns by a percentage point or two compared with the broad markets. What we’ve done is layer all of these factors on top of each other—like a factor lasagna.”

Of course, multi-factor funds are not new. Dimensional Fund Advisors have been running them for 30-plus years, combining exposure to small caps, value stocks, and companies with the highest profitability. More recently, iShares launched a family of FactorSelect ETFs based on similar strategies. But Fattore argues that his group has taken this idea to the next level.

“These other funds are totally inferior,” he scoffs. “Yes, they combine several of the factors, but the premiums clash with each other—it’s like pairing Chardonnay with chili. Our research has discovered a way to capture all of them simultaneously. So if the small-cap premium is 2% and the value premium is 2%, we will outperform by 4% before fees. Once you add screens for momentum, profitability, and the others, each one increases returns incrementally. It’s a very powerful model.”

Rigorous back-testing

If you’re skeptical, you should be. I was too, until Dr. Fattore showed me his back-tested results. He and his team ran simulations for 20,000 randomly generated multi-factor strategies using 60 years of data. Fattore and his team simply picked the one with the best results, removed the worst years from the sample so the results looked even better, and then came up with a compelling story about why the strategy should work in the future. “This was a genuine team effort,” he enthuses. “It’s not a simple matter to pull off this kind of data mining: it takes a lot of PhDs to do it properly.”

Fattore and his colleagues are now looking for ways to turn their research into an index that can be licensed by an ETF with a target fee of 0.75%. While they wait for Vanguard and iShares to return their calls, Fattore says the team is busy with the marketing plan. “We’ve already patented the name Beta Strategies and the ticker symbol BS.”

 

39 Responses to The Next Smart Beta Revolution

  1. Family CEO of CPP Investing April 1, 2016 at 7:29 am #

    I love these April Fools’ posts! Thanks for the chuckle and for proving that investing doesn’t have to be convoluted mumbo-jumbo.

  2. Cheapskater April 1, 2016 at 7:31 am #

    Not gonna lie – you had me shaking my head in disbelief until the end.

  3. Maxim April 1, 2016 at 8:09 am #

    Glad I checked my calendar.

  4. Kurt April 1, 2016 at 8:17 am #

    Thanks Dan,

    When are you going to update your model portfolios to include these fund?

    -Kurt

  5. Ace V April 1, 2016 at 8:35 am #

    Funny. But in all seriousness, run from all backtesting ’cause I have never seen poor back tested numbers!

  6. BruceMcK April 1, 2016 at 8:56 am #

    Will it be called the MoltiFattorETF?

  7. Adam April 1, 2016 at 9:09 am #

    I’m looking forward to switching all of my well diversified large-cap ETFs to these new focused funds a.s.a.p. Thanks! 🙂

  8. Michael James April 1, 2016 at 9:48 am #

    Just enough truth. Another good one!

  9. jamie April 1, 2016 at 10:19 am #

    I don’t know what everyone is talking about. This seems like the real deal–Dan is a responsible guy and I’m sure he takes his pivotal role in our financial planning seriously. Besides, I can’t resist lasagna!! I’m in.

  10. Andrew April 1, 2016 at 10:54 am #

    Great post Dan,

    You had me for a while!

    Andrew

  11. Phil April 1, 2016 at 12:28 pm #

    I had been waiting for this!

  12. I. Sharez April 1, 2016 at 12:47 pm #

    Does this have anything to do with Vanguard’s new ETF’s?

  13. Jessica April 1, 2016 at 1:20 pm #

    Nicely done!

  14. Peder April 1, 2016 at 1:45 pm #

    Dooh, you got me. BS. Great name for a ticker symbol. Funny thing is that I do back testing economic data for a living as a software engineer, and I can tell you for a fact that you do need to be smart or have a Ph.D to do this, otherwise I’d be out of work. 😉

  15. RK April 1, 2016 at 1:55 pm #

    Well done CCP, well done!

  16. Paul N April 1, 2016 at 2:28 pm #

    Have to admit I picked up on this in the first paragraph only because of being tricked by another Blog earlier (“Freedom 35”) this morning. He apparently quit his jobs and retired earlier in the month and explained how he did it…

  17. Mike April 1, 2016 at 2:29 pm #

    Gee Dan, I’m going to apply that strategy to my portfolio. If I buy a stock that outperforms the TSX by 5% then add another that outperforms by 4% then I’ll beat the market by 9%.
    Wow, no wonder it took a lot of PHd’s to come up with this great BS strategy.

  18. Chris Stephenson April 1, 2016 at 2:43 pm #

    haha- well done!

  19. BruceMcK April 1, 2016 at 3:28 pm #

    What qualifications and awards does Dr. Molti Fattore have? Anyone developing such an elite investment strategy must have several PhDs, a Fulbright Scholarship and most importantly, a Nobel Prize or 2 in Physics.

  20. Bernie S April 1, 2016 at 7:41 pm #

    I was shaking my head until I read the comments, hehe!

    “Factor Lasagna from Milan”

  21. Gerry P April 1, 2016 at 10:26 pm #

    Mmmmmm… factor lasagna. Deliziosa!

  22. john l. April 2, 2016 at 8:05 am #

    Brilliant Dan, even more so having read it on the 2nd not even thinking about well, you know when!

  23. Rob April 2, 2016 at 9:41 am #

    Well played Mr. B. Well played indeed.

  24. Sam April 2, 2016 at 1:21 pm #

    Darn-nit, you just gave me some heart palpitations with this one. Again.

  25. Tiffa April 2, 2016 at 9:09 pm #

    I want you to know that you really are making a difference in the lives of us regular folk.

    Case in point: we just made lasagne for dinner, entirely thanks to this post.

  26. oldie April 3, 2016 at 11:56 pm #

    Dan, your April Fools posts are so valuable for allowing us to slough off all our tension (derived from worrying that we may have forgotten some minuscule detail in the big clear picture of things that you have presented so clearly over and over again) in a big guffaw.

    But what I notice is a huge secondary benefit is that after your careful and consistent tutoring over the months and years to expose faulty statistical logic, wishful clairvoyant thinking and plain old deceitful lies by the investment industry, your elegant spoofing of stacking progressively less and less plausible strategies in progressively more ridiculous combinations is seen by us as hilariously inept — but is in reality only different by a minor degree from the outrageous claims we actually see in real life made in the Investment industry!

    What a bargain. Educational even in jest.

  27. Shaun April 4, 2016 at 7:12 pm #

    Personally I struggle with this one. I get it… a ridiculous exaggeration on data mining. But, but I still feel like multifactor tilt strategies and back testing are along for the smear. Not sure if that was the intent.

    Back testing historic data was instrumental for the identification of many of the factors that have outperformed over long periods including small cap, value etc. This is how Famma and French came up with the multi-factor theory that lead to the development of the Dimensional Funds which have all significantly outperformed their non-tilted counterparts since inception (this is true for the long running US funds, not the relatively new Canadian versions).

    It is back testing of data that led to the understanding of reversion to the mean. If this phenomenon was not expected to continue, rebalancing would be a much harder sell.

    Also, back testing of multi-factor regression is commonly used as a method to explain away outperformance of active funds such as Justin Bender’s post here:
    http://www.canadianportfoliomanagerblog.com/active-funds-exposed/

    It seems odd to me to make multi factor back testing the punching bag punch line. A healthy dose of skepticism is justified when looking at these things, but to me it is a slippery slope from this skepticism to ending up believing history provides no useful information for the development of a portfolio designed for the future.

  28. Prasanna Warnasuriya April 4, 2016 at 8:24 pm #

    Dan this is one of the best! I laughed and laughed
    Prasanna
    Maple.

  29. oldie April 5, 2016 at 12:08 am #

    Relax, Shaun, it’s just meaningless fun, and there’s nothing to read into. Dan isn’t above poking fun at his own industry, at things Italian, and his own colleagues (remember Bender the Robo-Advisor from last year?).

    It’s the inappropriate manipulation of data that’s being spoofed, and rather lightheartedly at that. I don’t see multifactor back-testing in particular being the punch line. Your healthy dose of skepticism regarding the latter may still remain intact without the slope needing to be slippery.

  30. shaun April 5, 2016 at 12:04 pm #

    Fair enough oldie.

    I truly do appreciate that Dan allows for open discussion here even when the opinion of some of his readers do not fully align with some of the finner details. I believe some back and forth and constant questioning is healthy for building confidence in your approach.

  31. Dave C April 13, 2016 at 6:01 pm #

    Dan in all seriousness, what are your thoughts on low volatility etf’s? Specifically XMI, XMV, and XMU? Could they be used as core holdings? Some say that they may drag slightly during bull markets but if you take a look back they kept up pretty well when the markets were going up. I’m thinking if held for the long term they could outrun their benchmarks. Your thoughts?

  32. Erik April 16, 2016 at 1:20 pm #

    Hi Dave,

    Dan has written about these products when they first were created in 2012 as well as about the low volatility strategy in general.

    http://canadiancouchpotato.com/2012/12/03/inside-the-ishares-minimum-volatility-etfs/

    Overall, my impression is that since they are designed to generally resemble the sector composition of the parent MSCI index, they can be used as core holdings in a portfolio.

    Historically, it seems the a low volatility strategy has outperformed by having more upside than downside capture; however, this may not be the case in the future. The 3-4 year outperformance seen since their introduction may persist; however, it could also be fleeting. An investor pursuing this strategy should be in it for the long term (>10 years).

    iShares has marketed these products as being designed to capture market returns with less volatility, which may promote better investment behaviour (not selling during downturns and buying disproportionately during upturns).

    As Dan has highlighted during his recent smart beta posts, choosing a strategy that is different from cap weighting may have multi-year periods of underperformance despite outperforming over a longer period, promoting tracking error regret, leading to suboptimal investor behaviour.

    http://canadiancouchpotato.com/2016/02/17/how-long-will-you-wait-for-smart-beta-to-work/

    Hope this helps a bit. Best wishes with your investing journey.

  33. Shaun April 25, 2016 at 3:30 pm #

    @Erik

    While I agree with most of what you have written I think you have missed an important point related to the low volatility strategies, specifically surrounding the sector compositions.

    All of the low volatility etfs that I have found excluding the ones provided by iShares do not put any constraints on the sector weights and by a combination of market cap and volatility of each stock. This results in a significant overweight of sectors traditionally referred to as “defensive”, including utilities, consumer staples, telecom, and healthcare. They significantly underweight more cyclical and volatile sectors such as energy, materials, and IT.

    The iShares low volatility funds have a cap on the amount each sector can deviate from the parent MSCI index but it is still a 5% allowed variance for each sector. So it still overweights and underweights the same as I listed above but not by as much as other MV funds. As an example the XIN currently has 11.4% allocated to energy and material stocks, while its low volatility equivalent only has 2.8% allocated to these sectors.

    This is an important point for investors in countries like ours that are heavily weighted in highly volatile sectors like energy and materials because the sector weights of the MV funds are more different that the parent index equivalents when compared to Canadian equities. The results is that the foreign MV funds have a lower correlation to Canadian equities than the cap weighted foreign funds.

    A big reason that MV funds have outperformed over the past few years is because they are significantly underweight energy and materials that have both been slaughter over that period. But of course the reverse is also true and when the cycle comes around and energy and materials outperform the broad index, then MV will likely underperform. This can be observed in the past couple months when both energy and materials commodity prices and stock prices have increased sharply.

    Another thing I personally like about MV funds is that their performance relative to the parent index is much more repeatable compared to all other smart beta funds. There are very few exceptions where they do not move in the opposite direction of natural resource stocks relative to the cap weighted counterpart. I believe it is reasonable and logical to expect this behavior to continue into the future because they will always underweight these highly volatile sectors.

    As I see it, we can not know which much certainty at all where commodity prices are going but we can know with some certainty how certain sectors will be affected when those commodity prices change. Since the Canadian economy, currency, and equities are so dependant on natural resources, to me it is prudent to at least attempt to design your portfolio to be as neutral as possible to commodity price changes. In my view MV funds are a ideal tool to be able to accomplish this.

    Having said all that I do agree that there is no guarantee (and not even probable) that MV funds will continue to outperform in the future, but I do believe there is a very strong case that they will continue to behave more differently than their cap weighted parents relative to Canadian Equities making them a better diversifier for some.

    Cheers,

  34. Dave C April 26, 2016 at 8:46 pm #

    @Shaun

    What are you thoughts on ZLD, ZLB and ZLU?

  35. shaun April 27, 2016 at 1:22 am #

    @ dave c

    Personally my preference of minimum volatility funds are the ishares versions not the bmo ones. I explained my rationale on the post linked below.

    http://canadiancouchpotato.com/2016/02/17/how-long-will-you-wait-for-smart-beta-to-work/

  36. Dave C April 28, 2016 at 10:19 am #

    @shaun

    You presented a reasonable argument for the ishares minimum volatility funds, but taking a look back and comparing the two side by side for performance the bmo funds have outperformed the ishares…..thoughts? I do also understand that past performance does not predict future results.

  37. Shaun April 28, 2016 at 2:44 pm #

    @ Dave C

    Neither have been around very long. A few years of history is not much to go off. I suspect part of the outperformance was because the BMO versions have even less high volatile sectors such as energy and materials that have been beaten up so bad. It is certainly possible that the BMO versions could outperform going forward. I have no way to predict that.

    For me having some amount of certainty about the range of sector weight variance from the mother fund, having more stocks in each fund, and a capped turnover rate making it more tax efficient, are feathers in the cap of the MSCI / iShares verisons that fit better with how I want to build my portfolio.

    One final note is that I personally don’t like the Canadian MV funds or really any or Canadian smart beta or REITs all for the same reason: The Canadian market is relatively small and not well diversified and so these tilts end up making funds that are heavily weighted in a few sectors and individual stocks.

  38. Erik May 1, 2016 at 7:30 pm #

    @Shaun

    Thanks for your perspective. I agree. I like the way that the iShares products are constructed seeking to mirror the parent index compared to others regarding.

    @Dave C

    I’ll comment on Canadian equity as I know the relevant issues better. ZLB has outperformed XMV by virtue of having a much lower energy sector makeup, among other reasons, by nature of it’s low beta make up (low volatility and low correlation to the underlying market).

    http://www.bmo.com/gam/ca/advisor/products/etfs#fundUrl=%2FfundProfile%2FZLB%23holdings

    When energy rallies as it has this past month, ZLB will lag as it was 100% percentile in returns over the past month.

    http://quote.morningstar.ca/QuickTakes/ETF/etf_performance.aspx?t=ZLB&region=CAN&culture=en-CA

    Trailing Total Returns ZLB

    The ZLB design would seem to have lower downside capture than the XMV but at the same time may also have less upside capture.

    Goes back to the point of picking a strategy and sticking to it for the full duration of a market cycle if not longer unless a person thinks that they can time the market cycles (which I can’t).

  39. Chucky May 14, 2016 at 9:39 am #

    I think it is better for some of us, to hold both the low volatility ETFs and the market index ones at the same time.Only time will tell.

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