Archive | 2016

Understanding the Quality Factor

This is Part 7 in a series about smart beta ETFs. See below for links to other posts in the series. In this installment, we look at the quality factor: the idea that companies with strong balance sheets and profitable businesses tend to outperform.


So far in this series we’ve looked at value, size, momentum and low volatility as factors linked to higher returns over time. The final factor we’ll examine is the newest and the most nebulous. There are several definitions of the quality factor, though all of them are associated with durable and sustainable companies with competitive advantages, strong balance sheets, stable earnings and high margins.

While it might seem obvious that such companies would deliver higher returns, that’s not how efficient markets are supposed to work. A company’s higher quality should be reflected in a higher stock price, and expensive stocks aren’t supposed to outperform: that’s why there is a value premium, after all. As Larry Swedroe explains, this surprising factor “is based on quality characteristics irrespective of stock prices, while a value strategy is based on stock prices irrespective of quality.”

In 2012,

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Understanding the Low Volatility Factor

This is Part 6 in a series about smart beta ETFs. See below for links to other posts in the series. In this installment, we look at the low volatility anomaly: the surprising idea that stocks with lower risk have tended to outperform.


In our introduction to smart beta  a couple of weeks ago, we discussed the capital asset pricing model (CAPM), which is based on the idea that you should expect higher returns from stocks with higher risk. That’s an idea many investors now take for granted, since being rewarded for additional risk makes intuitive sense.

But what if it’s not true?

As early as 1972, Robert Haugen and James Heins found the exact opposite in the data on US stocks between 1926 and 1971. The researchers uncovered a negative relationship between risk and return: high volatility stocks actually tended to deliver lower returns, while low-vol stocks outperformed. In the decades since, many researchers have demonstrated that this low volatility anomaly exists in stock markets around the world, and even in many bond markets.

As with all of the smart beta factors,

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Understanding the Momentum Factor

This is Part 5 in a series about smart beta ETFs. See below for links to other posts in the series. In this installment, we look at the momentum factor: the idea that stocks that have recently risen or fallen in price will continue that trend over the medium term.


Like value, momentum in the stock market is an old idea, but the academic evidence goes back only to the early 1990s. It was first documented in a 1993 paper suggesting you could generate excess returns by buying US stocks that performed well over the previous three to 12 months and selling those that performed poorly over the same period. Later studies found that momentum also exists in international markets.

In 1999, Mark Carhart published a now famous paper arguing that outperforming mutual funds cannot be reliably identified in advance. Carhart suggested fund managers who seem to have a “hot hand” are often just the lucky beneficiaries of momentum in stock returns. He eventually added momentum to the factors identified by Fama and French to create the Carhart Four-Factor Model.

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Understanding the Size Factor

This is Part 4 in a series about smart beta ETFs. See below for links to other posts in the series. In this installment, we look at the size factor: the idea that smaller companies should deliver higher returns than large-cap companies.


The idea that small-cap stocks have higher expected returns has a relatively long pedigree. The pioneering paper was authored in 1981 by Rolf Banz of the University of Chicago, who looked at US stocks from 1936 to 1975 and found that smaller firms, on average, enjoyed higher returns than larger companies. It found that smaller firms had higher returns, on average, than larger firms. That finding was confirmed in a ground-breaking 1992 paper by Kenneth French and Eugene Fama, the same one I discussed in my previous post on the value factor.

Over long periods, size has mattered a lot: depending how you define them, small caps in the US have outperformed large caps by about 2% to 4% per year since 1927 (the year the reliable data begin). And while most of the research on the small-cap premium has focused on US stocks,

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Understanding the Value Factor

This is Part 3 in a series about smart beta ETFs. See below for links to other posts in the series. In this installment, we look at the value factor: the idea that stocks whose prices are low relative to their fundamentals should deliver superior returns.


The roots of value investing go back to 1934, the year Columbia finance professors Benjamin Graham and David Dodd published Security Analysis, a biblical volume that is still studied today. Graham and Dodd outlined a strategy for identifying stocks trading for less than their intrinsic value, though they did not frame their work in the context of market-beating returns. That notion came much later, when academics began testing ideas about market efficiency.

In the 1970s and 1980s, a growing body of evidence began to show stocks classified as “cheap” delivered higher returns, regardless of their beta—that is, even if they were not more volatile than the overall market. Sanjoy Basu published a 1977 paper arguing that the performance of stocks was consistently related to their price-to-earnings (P/E) ratios. Another important paper in 1985 found a similar relationship between stocks with low price-to-book (P/B) values and argued this was “pervasive evidence of market inefficiency.”

Many subsequent studies supported the idea that it is possible to identify undervalued stocks by comparing market prices to the company’s fundamentals.

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A Brief History of Smart Beta

This post is Part 2 in a series about smart beta ETFs. See below for links to other posts in the series.


Smart beta is a relatively new term, but its roots stretch back several decades. Let’s look at the history of how the idea developed.

We’ll start with a simple question that has long been asked by students of the financial markets: what explains the difference in returns among stocks?

Back in the 1960s, economists and finance professors developed the capital asset pricing model (CAPM), which suggested that returns were directly related to risk. The formula began with a risk-free rate of return—for example, Treasury bills—plus an additional return for the stock market as a whole, called the equity risk premium. Then the model considered how sensitive a given stock is to the volatility of the overall market using a measure called beta. If a stock had a low beta—making it relatively less risky than the market—it should have a lower expected return. Stocks with higher beta should theoretically reward investors with a greater return.

CAPM is an elegant formula,

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Smart Beta ETFs: Your Complete Guide

Remember when index funds simply tracked the broad markets? I do, but I also remember renting movies on VHS and watching the Leafs in the second round of the playoffs.

Today there are ETFs tracking every conceivable segment of the market. Many are little more than flavours of the month, but one new breed is probably here to stay. Like old-school ETFs, they’re built from indexes, but they don’t simply track the whole market or a single geographic or economic sector. Instead, they focus on stocks with specific characteristics (called factors) that can be expected to lead to higher long-term returns.

For example, some of these ETFs screen for companies with low prices relative to their fundamentals (value stocks), while others cover only small-cap stocks, those trending upwards in price (momentum stocks), or those with lower volatility. Collectively these strategies have come to be called smart beta.

Consider an investor looking for an ETF of Canadian equities as part of a balanced portfolio. A traditional indexer would use a fund tracking the broad market, such as the iShares Core S&P/TSX Capped Composite (XIC), or the Vanguard FTSE Canada All Cap (VCN).

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An Even Better Reason to Fix Your Portfolio

So your portfolio is a disaster. Your RRSP is full of high-cost mutual funds, sprinkled with some random stocks and a bunch of exotic ETFs that seemed like a good idea at the time. You know it’s time to clean house, but you’re not sure where to begin. Well, here’s your chance to fix your portfolio and support a great cause at the same time.

Until last spring, Alex was a healthy, thriving four-year-old who loved playing soccer, swimming, riding his bike and playing with his two brothers. But in late April he was air-lifted from their home on Vancouver Island to the intensive care unit at BC Children’s Hospital, where he spent two weeks fighting for his life. Alex was diagnosed acute myeloid leukemia and has been receiving treatment for this disease throughout the summer.

Alex’s parents—who are clients of PWL Capital—are grateful for the excellent care their son is receiving, and they’re raising funds for the BC Children’s Hospital Foundation with the goal of helping other families dealing with childhood cancer.  My colleagues Justin Bender, Shannon Bender, Amanda Dalziel and I want to support Alex and other brave kids like him by raising $10,000 for their cause.

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How Foreign Withholding Taxes Affect Returns

In our newly revised white paper, Justin Bender and I explain the hidden cost of foreign withholding taxes on US and international equity ETFs. I gave an overview of the most important points in my previous blog post. Now let’s look at one of the more subtle ideas: how those taxes affect your personal rate of return.

Meet Julie, an investor who is looking to hold US equities in both her RRSP and non-registered account. After reading our paper, Julie knows the US imposes a 15% withholding tax on dividends paid to Canadians, and with US stocks yielding 2% these days, that would result in a drag of about 0.30%. So she decides on the following:

In her RRSP, Julie uses the Vanguard Total Stock Market ETF (VTI), because this US-listed fund is exempt from withholding taxes.
In her taxable account, Julie uses the Vanguard U.S. Total Market Index ETF (VUN), the Canadian-listed equivalent of VTI. This ETF is denominated in Canadian dollars, which makes it cheaper and easier to trade. Although the fund is not exempt from the foreign withholding taxes in a non-registered account,

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