Your Complete Guide to Index Investing with Dan Bortolotti

How Long Will You Wait for Smart Beta to Work?

2018-05-29T22:03:12+00:00February 17th, 2016|Categories: ETFs, Research, Smart beta|Tags: , |26 Comments

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), which have greater exposure to the small-cap, value and profitability factors.

The academic research on factor-based investing is robust and convincing, and building your portfolio using these principles may be rewarding over the long term. Ben Carlson thinks so, too, despite the emphasis he puts on simplicity. But he has some cautionary words for those who are ready to jump on the smart beta bandwagon. “I think these strategies can make sense as part of a broadly diversified portfolio if you know what you’re getting yourself into,” he writes.

A costlier, bumpier ride

Let’s start with the most obvious caveat: smart beta is cheap compared with active strategies, but it’s significantly more costly then traditional ETFs. Cap-weighted ETFs carry almost negligible costs these days, with fees as low as 0.05%, while factor-based funds tend to have MERs in the range of 0.40% to 0.80%. That means they need to deliver significant outperformance before fees to simply break even on an after-cost basis.

Second, any outperformance is probably going to involve a rockier ride. While it’s not true over every period, small-cap and value stocks are typically more volatile than the broad market, so their excess returns may require you to endure more swings in your portfolio. Over the last five years, for example, that standard deviation (a measure of volatility) for both value and small cap stocks was higher than that of the broad market in Canada, the US and international markets. And as Carlson notes: “One of my common sense rules of thumb states that as the expected returns and volatility of an investment increase, so too does poor behaviour.”

Which brings us to the biggest challenge for investors who use smart beta strategies.

The waiting is the hardest part

Investors who embrace smart strategies are usually familiar with the research showing that small-cap and value stocks have outperformed over the very long term in almost every region. But few appreciate that to those premiums can take a long time to show up—and were not talking about a mere five or 10 years.

In his book, Carlson explains that from 1930 to 2013, small-cap value stocks in the US delivered an annualized return of 14.4%, compared with 9.7% for large caps. However, small-cap value lagged the S&P 500 for a 15-year stretch in the 1950s and 1960s, then for seven more years from 1969 to 1976, and finally for a gruelling string of 18 years in the 1980s and 1990s. “Eventually they paid off, but that’s a long time for investors to wait. Patience is a prerequisite for these strategies.”

That’s an understatement. It’s not uncommon for investors to lose faith in a strategy after a year or two. It’s hard to imagine many will hang on to an underperforming smart beta fund as it lags the market for even five years—let alone 18—because they’re confident it will outperform over a lifetime. Almost no one has that kind of patience—with the possible exception of Leafs fans.

“You have to commit to these types of strategies, not use them when they feel comfortable,” Carlson says. “The reason certain strategies work over the long term is because sometimes they don’t work over the short to intermediate term.”

Tracking error regret

Just this week, Larry Swedroe expanded on this idea by looking at the probability that the small and value premiums will be negative over various periods. He demonstrates that there’s a significant chance of underperformance over even a decade or two. “My almost 20 years of experience as a financial advisor has taught me that even the most disciplined investors can have their patience sorely tested by as little as even a few years of underperformance,” he confirms, “let alone a 10-year period without higher returns for value (or small, or international, or emerging market) stocks.”

Swedroe goes on to coin a brilliant term for the anxiety indexers feel when their smart beta strategies go awry: tracking error regret. “These are investors who regret their decision to maintain a portfolio that performs differently than the market. Tracking error regret causes many investors to abandon their well-thought-out, long-term plans.”

The point here is not that you should ignore alternatives to portfolios built from traditional index funds. Smart beta strategies may indeed reward the patient, disciplined investor over the very long term. But no investors should ever feel they’re settling for second-best with a simple solution. In the end, these traditionalists will likely find it easier to stay on course, and may just end up looking like the smart ones.



  1. Jonny February 17, 2016 at 8:36 am

    Hi Dan, Could you do an article on high yield bond funds, like HYG. I’d like to know your thoughts.

  2. Scotty February 17, 2016 at 11:43 am

    This whole “smart beta” thing definitely catches my interest, but that extra 0.7%-ish in MER just seems tough to swallow for now. I’ll need to spend a bit of time researching products available to Canadians, but I’m guessing there are only a few right now.

    However, maybe as these concepts become more and more popular we’ll see a second race-to-the-bottom event between ETF providers.

  3. phil February 17, 2016 at 11:44 am

    Dan, well written post! Thanks. This relates to those who proport using 100% equities in a portfolio. Equities do have a higher expected return than bonds but will the investor stay fully invested long term to reap the rewards. If I remember correctly you had a post which explained how an 80/20 stock/bond portfolio had a very similar expected return but with less volatility. It seems that putting some value on individual stick-to-itiveness, especially when managing your own funds is not only prudent but likely to provide superior long term results. As you already mentioned, smart beta could be expected to outperform plain vanilla but will an investor stick to the plan for decades? If you are the type of person looking for every possible advantage I can’t see how you will not at some point in the next 40 years think that another method could out preform and give it a try.

  4. Trevor February 17, 2016 at 12:11 pm

    Which is why I’m glad you simplified your portfolios away from ones including the small caps to just the broad index funds. I had the impression more volatility was the risk but the idea the returns would be lower for 15 years didn’t become apparent until I researched the history. There’s long term and then there’s very long term. Nice for it to be highlighted here in this blog post. .

  5. Amber Tree February 17, 2016 at 12:57 pm

    A smart beta approach that I am interested at is the equal weight approach. I have on my todo to find out if it actually works or not.
    A friend of mine is a true believer of momentum, and showed me the data to back this up. Would the higher expenses be worth the return? Will I have the time to implement it myself? Not sure yet.

    My personal lazy portfolio tries to cater for the small cap… I have 20 pct forseen for that.

  6. hdm February 17, 2016 at 1:25 pm

    “Don’t mention smart beta in this office!’’ Jack Bogle, 85, founder of Vanguard Group and father of the index fund, tells Bloomberg Markets. “I don’t even know what it means. Baloney. Marketing!’’

    I suppose it’s eating into his profits! But, I think he’s right — clever marketing.

  7. Shaun February 17, 2016 at 2:17 pm

    Great Post Dan,

    When it comes to the popular tilts of small cap and value, and even more so for momentum, I agree that investors will likely have a bumpier ride. These factors are riskier which should mean they will have higher expected returns. If we own them we can be sure to get all the extra risk, but less than of the reward due to the higher costs. The lion’s share of incremental costs are somewhat hidden because they are related to higher turnover leading to higher tracking error and tax inefficiency above and beyond the higher MERs.

    To me the starting point of a Canadian portfolio should be the broad cap weighted Canadian index because they are the absolute cheapest, have the lowest tracking error, don’t have any foreign withholding tax, and are the most tax efficient. So unlike the smart beta funds you will get almost all the reward you pay for in risk. From there any asset classes you add should be added with the intent of diversifying risk specific to Canadian equity. Obviously adding Canadian bonds is a great first step. But when it comes to equities, I believe international minimum volatility funds offer better diversification than a cap weighted world fund.

    To me diversification is not just about adding as many companies and countries as possible to the mix. We should be aiming to include companies and countries that behave differently that our Canadian Index to get the correlation as low as possible. Everyone knows Canadian Equities are heavily weighted in Financials, Energy, and Materials stocks (combined amount to about 68%). The flip side is that we are very short on defensive sectors like utilities, telecom, healthcare, and consumer staples (combined only amount to 10%).

    If we simply add a an all world cap weighted fund (2/3), to our Canadian equity cap weighted fund (1/3), then the resulting portfolio will still be heavy on Financials and Natural Resources, and light on defensive sectors.

    An alternative is to use the iShares minimum volatility funds for a portion of the global equity. These funds not only weight the stocks by those that have had lower volatility, but also weight the sectors and countries based both on relative correlations and individual volatility in an attempt to minimize the overall volatility. The result is that they have significant underweights in cyclical natural resource sectors and overweight defensive sectors. This approach would provide a more evenly balanced sector weighted portfolio for Canadians.

    I did some back testing for the last 15 years to see how this approach would have worked. The resulting reduction of portfolio volatility and increase in returns relative to using cap weighted world index as a diversifier for a Canadian index were so extreme I don’t even want to quote it since it would appear as an exaggeration of the merits of the theory. Have a look yourself and you will see that almost without exception, when Canadian equities were down significantly, the all world minimum volatility outperformed the all world cap weighted version. And almost every time the minimum volatility underperformed it’s cap weighted counterpart, it happened when Canadian equities were having a big up year.

  8. Paul G. February 17, 2016 at 3:10 pm

    Very interesting. The possibility of tracking error regret is what keeps me in very plain, very vanilla index etfs (with a very mild overweighing of mid/small caps)

  9. Shaun February 17, 2016 at 3:22 pm

    The tracking error regret could still play in when assessing using minimum volatility funds since they are designed to exhibit less extreme highs and lows so they would likely underperform during major bull runs especially those that are driven by increase in commodity prices. However, these MV funds do frequently work as advertised and drop significantly less than the parent index, not only during major bear markets, but also in small frequent corrections. To me being able to frequently see that they really drop on dips provides some confidence that they are working as advertised even if they are underperforming in a bull run. For me at least, this alleviates the much of the tracking error and patience concerns.

    Recent examples:
    Sept 22 – Oct 2015: XWD -5.5%, XMW -1.0% (4.5% less drop)
    Aug 5- Sept 30 2015: XWD –8.9%, XMW -5.6% (3.3% less drop)
    Oct 22 2015 – Jan 20 0216: XWD – 14.1%, XMW +2.1% (16.2% less drop),XWD.TO

  10. Shaun February 17, 2016 at 4:45 pm

    Correction… My apologies for the error. Recent examples:
    Sept 22 – Oct 2014: XWD -5.5%, XMW -1.0% (4.5% less drop)
    Aug 5- Sept 28 2015: XWD -10.0%, XMW -6.0% (4.0% less drop)
    Dec 29 2015 – Feb 10 2016: XWD -10.8%, XMW -3.5% (7.3% less drop),XWD.TO

  11. Tristan February 17, 2016 at 5:10 pm

    @CCP: Wouldn’t it be better to use cap weighted small and value ETFs (such as Vanguard’s small cap value ETF, VBR) if one wanted to “tilt” to the small cap and value factors, rather than the more expensive and often less tax efficient “smart beta” products? Eg. VBR has an MER of only 0.09%, and being cap weighted is quite tax efficient.

  12. Canadian Couch Potato February 17, 2016 at 5:41 pm

    @Tristan: It’s a great question, and something I’ll be exploring in more detail in future work. With small cap funds, the methodology is straightforward (companies are simply screen for market cap), but with the other factors, the specific methodology used to capture the expected premium is hugely important, and they vary widely among funds. Vanguard has one set of value screens, but other fund providers use very different ones. Look at the drastically different strategies used by the low-volatility funds from BMO, iShares and PowerShares. One of the problems with choosing a smart beta strategy is that you need to decide which specific methodology you want to use, and I’m not sure how one would make an informed decision.

    Rick Ferri is one proponent of what you suggest: simply look for ways of accessing the premiums as cheaply as possible with funds that use screens but are still cap weighted:

  13. Shaun February 17, 2016 at 7:08 pm

    I could not agree more regarding different strategies used to capture smart beta factors. There are many ways to skin these smart beta cats and each method can provide much different results as you have highlighted in earlier posts. Low volatility is no exception.

    I am just one guy with an opinion, but my thoughts on how to make an informed decision is to read all the information available on the different methods being used and decide which is best suited to accomplish what you are trying to do.

    I have done this for all available low-volatility funds I could find. To me the methodology that makes the most sense is the one used by MSCI and tracked by iShares for the following reasons:

    1) MSCI cap the country and sector weights at 5% variance from the parent index. This way you can have some level of assurance within a band that you know what you are getting. There is no such assurance from the other providers and this is evident in much larger sector and country weight variances in their funds. It seems to me that having no cap could produce some unintended country and sector weightings and would add some uncertainty to the results. The net result is that Powershares and BMO have more drastic tilts, while MSCI provides a more moderate version.

    2) MSCI is they only one that I found that uses sector correlations in the weighting methodology. Meaning they model how different countries and sector move relative to each other and try to weight them to offset as much as possible. Obviously correlations change with time and this will be far from perfect but it makes sense to me to at least attempt to get it in the ballpark.

    3) MSCI has a hard limit of 20% annual turnover to minimize cost and tax implications. I could not find any mention of any turnover considerations on the other funds. Being that they have no constraints on countries or sectors, I suspect that the turnovers will be higher on these versions over time.

    4) MSCI has close to double the stocks in each of their funds relative to BMO providing better security diversification.

    Just one guys thoughts…

  14. Julio February 18, 2016 at 1:31 pm

    In fact, most low-volatility iShares ETFs are Morningstar 5-star.

    Could be these ETFs used as core holdings?

  15. Scotty February 18, 2016 at 3:36 pm

    I dunno guys – I hold equity for long term gains, not to lower my volatility. Pretty sure the long term annualized return of a total market holding after fees is going to be lower than a low-volatility fund after fees.

    If volatility is causing you sleepless nights, consider boosting your fixed income allocation.

    My take is that these funds are only getting attention because of the recent bear-ish markets. Pretty sure everyone is going to ignore these / switch back to total market indexes once the next bull gets going.

  16. Will February 18, 2016 at 3:46 pm


    Thanks for all that great info. I’ll admit I’ve never really considered the low volatilty ETF’s before, but you’ve definitely convinced me to take a look. I completely agree that Canadian content should be standard cheap ETF’s, and that international exposure should serve it’s purpose of offsetting the wacky sector exposure of canadas market.

    Is there a reason to suggest XWM as a 2/3 portion instead of XMI and XMU for international/us (aside from saving on fees by holding just 1 fund?). I’ve looked at potentially using a world ex-canada ETF in place of seperate US/international ETF’s before, is there a similar low volatility product or are you stuck with that 5% canadian in XWM? And do you bother factoring that into your portfolio wieghtings?

  17. Shaun February 18, 2016 at 4:05 pm

    Morningstar star ratings are just a reflection of how the fund has performed in recent history relative to its category peers. It is a backward looking metric. Many Morningstar studies have shown that past performance (and star ratings) are not very good predictors of future performance, and that low cost is a better predictor of future performance. So to me star ratings do not add any credibility to the theory.

    It is true that the minimum volatility funds have outperformed recently especially during the recent months when markets have gone for a dip, but to me this is more of a deterrent from switching into them now. Think of it this way, if you already had minimum volatility funds in your portfolio, they would have recently outperformed (as indicated by the 5-star rating) and as a part of rebalancing you would have been selling them to buy recent poor performing asset classes (like Canadian Equities). If you are ever going to make a change to your asset allocation (not a good idea to do often), the best time to buy more of something is when it has recently underperformed. We never know when a certain asset classes will underperform, but we can recognize when it has occurred.

    Personally I believe in using MV funds as a core holding but that is only my opinion and I think that most readers here would disagree with me. So take my opinion with a grain of salt.

  18. Julio February 18, 2016 at 4:37 pm

    Thank you for that Shaun.

  19. Shaun February 18, 2016 at 4:55 pm

    @ Will
    I am not a professional and as such can not provide any specific advice to anyone. I was just showing XWM as the simplest example. iShares has MV products for US, International, Canada, World, and Emerging. As I mentioned, part of the method they use is looking at correlations between countries and weighting accordingly up to a max of 5% variance of the parent. These rules are the same in the world version as the international and emerging versions. As an example, if a country makes up 5% of the world, in the world version it could be weighted between 0-10%. If that country is in Europe, it may make up more like 20% of the international parent index and so could be weighted 15-25% of the international MV fund.

    Ultimately it means that holding just the world version would mean a larger range of portfolio variation of country weights than owning the individual US and International versions. Which is better is hard to say, and as Dan pointed out is part of the challenge with picking smart beta funds.

    @ Scotty
    Volatility is not causing me sleepless nights. However who doesn’t want lower volatility all else being equal. That is the point of diversification. I can assure you that I am not just giving them attention due to the recent dip, and I will not be throwing in the towel on them when they go through inevitable periods of underperformance.

    I do not share your opinion that the total market will certainly provide higher returns than low volatility funds. Especially not total portfolio returns with a combination of World MV as a compliment of Canadian total market. To date MV funds have provided significantly higher market returns with significantly lower volatility, lower drawdowns, with a lower correlation to Canadian equities. This is true for all of the 5 MSCI MV funds available in Canada.

    Have a look:

    Some of this data is backtested and MSCI only started these indices in 2008 as I understand it. It only became available through iShares in July 2012.

    To me this past outperformance is too extreme to be expected to continue, and there are bound to be periods of underperformance as per Dan’s main point of the article. But, the logic I laid out above, combined with the past outperformance leads me to believe that the risk adjusted returns of this strategy will outperform over the long term, at a muted rate compared to history.

    Again, only my opinion which is not commonly accepted.

  20. Gerry P February 21, 2016 at 4:01 pm

    @Shaun and CCP: I use an ishares minimum volatility ETF (XMM) for most of the portion of our portfolio allocated to emerging markets. My reasoning on this is similar to your point about international ETF’s in general: cap-weighted emerging market ETF’s are usually heavily invested
    in commodities and financials and hence usually have a high correlation with Canadian broad-index ETF’s. The minimum-volatility tilt, along with fact I’ve allocated a relatively tiny portion of the overall portfolio to emerging markets, reduces that correlation somewhat and thus provides a bit of diversification. This diversification may help a little in a portfolio that I’ve come to realize, lately, is still regrettably overweight in energy and other commodities, financials, and Canadian dollars.

  21. Garth February 21, 2016 at 8:01 pm

    There seems to always be a strategy or a tilt that favors the particular situation that we find ourselves in at any time in our investing lives…there always seems to be a rationalization or reasoning that fits. But if there is any constant theme in all the advice given here and in particular, the last few blog entries here at CCP, it is that simplicity and staying the course seems to win out in the end, if we just give it a chance. We must somehow resist the urge to constantly tinker and adjust, no matter how natural and persuasive the arguments seem to be…and this is simple, but very hard to do.

  22. Shaun February 22, 2016 at 11:20 am

    @ Garth,
    “Everything should be as simple as it can be, but not simpler” – Albert Einstein

    I love this quote and apply it to my both my life and investments strategy. I fully agree that simple is far better than complex. I am 100% on board with indexing and simple asset allocations, setting targets and rebalancing. But we must also acknowledge that oversimplifying can also be detrimental. For example the simplest equity allocation would 100% cap weighted for the world without any overweight to Canadian equities or for rebalancing between US, International and Canadian. But I have never read a single recommendation from anyone to do this, and for good reason. CCP has explained the benefits of overweighting Canadian equities in previous posts and I agree fully with his logic.

    To me when considering adding any complexity to a portfolio, you have to weigh two things:
    1) What is the probability that the added complexity will improve the long term risk adjusted returns of the portfolio net of fees if the new plan is followed exactly?
    2) What is the probability that you will be able to stick with the more complex plan over the long run, and what could be the impact if you bail at the worst time?

    I think these questions sum up the spirit of CCP’s post here.

    I think most readers would agree that adding the complexity of splitting out Canadian Equities and overweighting it is a sound choice and worth the extra complexity.

    The majority of the academic research done on passive investing has been focused on the American markets. The US market is very large and diverse. And thus they do not have the same issues with the local economy and currency being heavily tilted to a few sectors as we do in Canada. I have looked and not found a lot of papers or books on how best to deal with this issue that we have in Canada. To me having about 1/3 Canadian cap weighted equities, 1/3 cap weighted foreign equities, and 1/3 MV weighted foreign equities, makes more logical sense by equalizing the sectors and this added complexity is worth it to me. But certainly, it would be a bad idea for anyone to implement this or any other strategy that they do not fully understand or agree with the logic, because it would likely result in them bailing at the worst possible time causing more harm than good to the long term returns.

  23. Gerry P February 22, 2016 at 3:05 pm

    The reasoning behind Garth’s approach seems fairly sound to me. Allocating 1/3 of one’s equity investments to Canada has some tax advantages, but has the drawback of investing in a Canadian market dominated by cyclical sectors. There may be an advantage to finding a simple way to seek some increase in sector diversification, as Garth has done with MV global or international ETF’s.

    I also agree with CCP that staying with a “smart-beta” approach may require great patience, but I see Garth’s point that any investor is more likely to show that patience if they have taken an approach because they understand the “logic”; i.e. because research, evidence and reason seem to back up a long-term investment choice.

  24. Erik February 23, 2016 at 12:05 am

    Thanks for the article Dan.


    For retail investors, I agree regarding looking at the logic of various investment strategies and how that may allow investors to stick with a plan despite interval under performance.

    For example, I would invest in ZLB because of reading Dan’s article and the BMO article
    about the theory behind low volatility and understanding that it is designed to give me market or perhaps above market returns with lower volatility over the long term, not because it is a five star fund or was Morningstar’s best equity ETF award winner.

    The recently developed Factor Select products from iShares seem to offer retail investors an opportunity to obtain a fund with a size and value tilt, like the DFA funds, along with momentum and value so one doesn’t have to try to time the factor cycles or face longer periods of under performance, though time will tell.

    I only decided to put some money in these products as a complement to my core portfolio having read (in addition to Dan’s excellent articles, Swedroe, and Bernstein):

    The Vanguard paper that Dan had linked (the cyclical nature of factor investing was helpful as a quick figure)

    The MSCI papers describing the theory behind factor-based portfolios

    The etfinsight webinar about the products

    And the ishares webinar about the products

    Having understood the logic, I feel that I can navigate any long term tracking error regret and stay the course.

    I think that keeping on a low information diet will help too!

    Should I sell everything this week (or should that have been last week)!

  25. Gerry P February 25, 2016 at 12:36 am

    @Shaun and Garth.I’m sorry: I just noticed that I accidentally switched your two names in my two previous missives. Apologies to both of you.

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