Archive | Smart beta

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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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.

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How Long Will You Wait for Smart Beta to Work?

In my last post I shared some insights from Ben Carlson’s A Wealth of Common Sense, which argues that investors are generally better off keeping their portfolios simple and straightforward. This idea has little appeal for index investors who hope to improve on plain-vanilla funds by using so-called smart beta strategies.

“Smart beta” refers to any rules-based strategy that attempts to outperform traditional cap-weighted index funds. Now more than a decade old, fundamental indexing is the granddaddy of smart beta, while factor-based strategies are the newer kids on the block. In each case, the goal is to build a diversified fund that gives more weight to stocks with certain characteristics (value, small-cap, momentum, and so on) that have delivered higher returns than the broad market over the long term.

Many proponents of passive investing see huge potential in factor-based strategies because they combine the best features of indexing—low-cost, broad diversification, and a rules-based process—with the potential to overcome the shortcomings of traditional cap-weighting. Indeed, many of our clients at PWL Capital use a combination of traditional ETFs and equity funds from Dimensional Fund Advisors (DFA),

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It’s Better With Beta

The title of Larry Swedroe’s latest book, The Incredible Shrinking Alpha, raises a question: what happened to the idea that skilled managers can consistently beat the market? In a recent interview with Swedroe, we discussed the idea that this ability hasn’t really disappeared: it’s just that “alpha has become beta.”

What exactly does that mean? In investing jargon, alpha is the name given to the excess return a fund manager achieves through skill. Beta, on the other hand, refers to the returns available to anyone who is willing to accept a known risk. When Swedroe says “alpha has become beta,” he simply means that anyone who understands how to structure a portfolio can increase their expected returns by simply changing their exposure to specific types of risk, known as “factors.”

A factor is a characteristic of a stock that affects its expected return and risk. Factor investing (sometimes marketed as “smart beta”) means identifying which of these characteristics might predict higher returns in the future—even if it also brings more risk—and then building a diversified portfolio that captures those returns in a systematic way,

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Why Your Problem Is Not Your Funds

In Monday’s post I looked at “smart beta,” which promises to outperform cap-weighted indexing strategies. I’m frequently asked if I think Couch Potato investors should dump their traditional index funds in favour of these tempting alternatives. Here’s why my answer is no.

I could rhyme off technical reasons for being skeptical about the outperformance of alternative indexes: the research ignores costs and taxes, the strategies may not work in the future, and so on. But I won’t go down that road, because the most important reason is not technical, but behavioral.

Everything beats the market—except investors

To recap, two recent papers from Cass Business School in London looked at US stocks from 1968 through 2011, a period when a cap-weighted portfolio would have returned 9.4% annually. (Canadian stocks had an almost identical return over those 43 years.) The researchers examined 13 alternative strategies—which favoured value stocks, small-cap stocks or low-volatility stocks—and found all of them outperformed, with returns between 9.8% and 11.5%.

For many people, the takeaway from these findings is, “I should use alternative indexes, because I can beat the market by a point or two.” My reaction is different: I want to know how many investors earned even 9.4%.

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Does “Smart Beta” Really Beat Cap-Weighting?

“Smart beta” has become a buzzword in investing circles, especially among pension funds and other institutional investors. The term may be new, but the idea isn’t: it’s about looking for ways to capture the returns of an asset class with a strategy other than traditional cap-weighting. These alternatives include fundamental indexing, equal-weighted indexes, low-volatility strategies and a few more exotic techniques.

A growing body of evidence has highlighted the inherent flaws in cap-weighted indexes, which are undeniable. By their nature, cap-weighted indexes give the most influence to the largest companies, as well as any that happen to be overvalued. That’s a potential problem because these are companies that are most likely to underperform the broad market over long periods.

A second potential problem with cap-weighted indexes is concentration. This isn’t an issue in huge markets like the US, or in a multi-country index like the MSCI EAFE. But it’s a concern in small countries like Canada (where Nortel once represented about a third of our entire stock market) and in individual sector funds.

Dunce caps?

These flaws are real, but if you listen to the chatter of investment firms these days you’d think cap-weighting is a strategy for dunces.

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Where Do Returns Come From?

You don’t need a lot of mathematical horsepower to be a Couch Potato investor. Indeed, simplicity is one of the strategy’s virtues: just keep your costs low, diversify widely, and stick to the plan. But if you’re a finance geek, it can be fun to delve into the more arcane theories behind index investing.

One of the most interesting chapters in Rick Ferri’s The Power of Passive Investing (Wiley, 2010) looks at how academics have learned where investment returns come from. Twenty years ago, if a money manager beat the market, it was pretty much impossible to explain why. Was the outperformance due to skill (or alpha)? Did the manager simply take more risk? Or did he just get lucky? Until recently, we didn’t have the tools to answer those questions.

Now we can get very close. The work of professors Eugene Fama and Kenneth French in the 1990s showed that a portfolio’s returns can be largely explained by three risk factors: its overall allocation to stocks (called the market factor, or beta), its exposure to small-cap stocks (the size factor), and its exposure to stocks with high book-to-market ratios (the value factor).

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