How to get started with smart beta ETFs

These ETFs focus on high-return factors



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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 detailed look at several smart beta indexes and see whether they deliver on their promises.

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