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). Both include all but the smallest of companies trading on the TSX, and the size of each holding is proportional to the company’s market capitalization. (“Market cap” is the current share price multiplied by the total number of shares outstanding.) So the big banks make up the largest share of these ETFs—say, 3% to 7%—while smaller firms make up only a fraction of a percent.
By contrast, an investor interested in smart beta might consider an ETF that selects and weights Canadian stocks based on something other than market cap. The First Asset Morningstar Canada Value (FXM) focuses on companies that appear to be underpriced and weights them all equally. The iShares S&P/TSX Small Cap (XCS) excludes large companies altogether. The BMO Low Volatility Canadian Equity (ZLB) zeroes in on companies that are less sensitive to fluctuations in price. We can classify all of these ETFs as smart beta because they’re designed to capture one of the factors shown to have delivered higher returns than the broad market, or at least similar returns with lower risk.
A critical look
So, is smart beta a legitimate strategy or just the latest marketing gimmick from the investment industry? If it’s for real, can ETF investors profit from these strategies? And what are the pitfalls you might face? Over the next few weeks I’ll set out to answer these questions in a series of blog posts about this increasingly popular idea.
I’ll kick off the series by providing some background on how smart beta (also called factor investing) has evolved since the 1960s. Then I’ll introduce the most important factors: value, size, momentum, quality and low volatility. I’ll devote a full blog post to each, explaining the academic evidence for the premium, suggesting why it existed in the past, and whether it might persist. I’ll also provide examples of ETFs designed to capture the premium.
Once we’ve covered the individual factors, I’ll take a look at the growing number of “multifactor” models: these are funds that target several of the premiums rather than a single one.
Finally, I’ll help investors decide whether they should incorporate smart beta ETFs into their own strategy. We’ll spend some time on the challenges, including higher costs and the need for long-term discipline. And with the help of my colleague, Justin Bender, we’ll take a look at some smart beta indexes and see whether they deliver on their promises.
Looking forward to it!
Step aside, Game of Thrones! I’ve got something new to binge on!
Would appreciate it if you and Justin compared ZWH And ZDY as part of your review. I’d like to see which one you think will likely outperform over the long haul.
@Simon: Wow, I think you’re setting yourself up for a big disappointment. :)
when will it start?
gn
@Gary: First post on Thursday, then hopefully two per week after that.
when will it start?
Hi There; I appreciate the work you are doing,on behalf of us ltle retail guys.Thankyou.
A topic you may be interested in sharing with your readers is this: I just looked at VGG a canadian version of VIG:US in which all of VGG porfolio is held.The mer in canada is .3 in us .09.The dividend in canada is 1.5 IN THE US IS 2.08.This seems to indicate a distinct advantage in spite of the exchange to YS dollars.Am I missing something? I hope not.What are your thoughts here?
Thanks
( The same thing occurs with VTI:US and its canadian counterpart)
Lachlan Clement
@Lachlan: The MER is typically higher in Canada for all Vanguard and iShares products. The yield should be similar, though the way yield is measured and published is different in the two countries. Foreign withholding taxes can also make a difference. This should help:
https://canadiancouchpotato.com/2014/05/20/ask-the-spud-why-do-etf-yields-differ/
Sounds great, I’ve followed Min Vol and Quality since AOs and AMs started thinking of them as good alternatives, look forward for your input.
This made me check my calendar to make sure it wasn’t april 1st. Is this for real?
Excellent! I’m looking forward to the series :)
@CCP: I hope you will talk about RBC ETFs. They are relatively new on the market (2014), but I like the fact that they have all the core assets needed to build a portfolio, including 1-5 year laddered Canadian bond. I am not sure to invest in smart beta as I still believe old-school index investing is the way to go, but I am waiting for your next posts to get your thought about it.
Very much looking forward to this.
Very excited for this series!
I thought this was a joke as well, adding complexity in hopes of finding the secret sauce. This will be interesting…
@Phil and JP: Fair enough. :) There’s a lot of hype around smart beta, but the overall idea is worth a serious look. I’m pretty sure at the end of the series you won’t think I’m recommending complicated strategies for DIY investors.
I like small and value… Low volatility – not so much, such companies appear overpriced.
Leafs in 2nd round of the playoffs???? Wow you are older than I thought ?
Excellent timing given Vanguard’s recent launch of VLQ, VVO, VMO, and VVL.
@Mike: I received a note from BMO regarding your question:
Was with FXM (value) and WXM (momentum) for half a year. Then switched to ZLB (low vol).
Although my rule is to buy on a 5 day low.
Honestly, buying VUN or VCE would be easier. Lower mer and the radio talks about TSX so I know when to buy more if I have spare cash.
FXM,WXM,ZLB don’t track index so I have to remember to check the graphs to figure out when to buy.
If. And only if they beat the index are they good. Owell. Past performance indicate they beat the index. Although that is past performance. We’ll see how many people will get burned just by jumping into the bandwagon without research… Me included. Lol.
YTD for ZLB is lagging VUN/VCE. With higher MER meant I should’ve been lazy and just indexed it.
This promises to be both timely and useful advice, Thanks CPP.
Thanks for the comments on ZWH vs ZDY. The question arose when I did a comparison over the last two years and found that ZDY outperforms ZWH in total return by about 4.5%. This got me wondering whether ZWH was worth the premium being paid for the MER 0.61% vs 0.34% for ZDY. Ironic that you concluded with comments about taxes etc. because that’s what started me in the analysis, I was attempting to determine which one was best for taxable portfolio and which was better suited for RRSP portfolio. My conclusion ; zwh -> RRSP w/drip and ZDY -> taxable. Agree?