by Susan Yellin
Amid volatile markets, ETF investors hoping to reap better returns – and continue paying lower costs – are turning to “smart beta” alternatives to traditional index funds.
While market capitalization-based index ETFs reduce systematic risk, increasing evidence shows other factors may produce longer-term outperformance, says Barry Gordon, president of Toronto-based First Asset.
“Smart beta-index products have evolved out of empiric-al research that says there are better risk-adjusted ways to invest your portfolio for the long term,” says Gordon. “They represent the building blocks of a comprehensive portfolio that focuses on these long-term value factors.” By screening for select factors, issuers tailor ETFs to match specific portfolio objectives. For example:
Low volatility: Contrary to the conventional wisdom that you have to tolerate higher risk to get higher returns, research has determined that lower-risk stocks can outperform over time, particularly on a risk-adjusted basis, says Yves Rebetez, managing director of the website ETFinsight.ca.
Yield/dividend: Over the long term, dividends can form an important component of the total return package for investors, especially with historically low interest rates and preferential tax treatment. But there are times when a high dividend yield may be a precursor to a dividend cut, so this type of ETF screens for potential traps.
Momentum: This type of ETF relies on the premise that if a stock moves in a specific direction, underpinned by fundamentals such as rising sales or earnings, the momentum is likely to continue. “If you can screen properly for it, you can do well. The magic is being able to pull the chute before the momentum stops – an ETF can deliver on this strategy by refreshing the basket to ensure there are no ‘losers,’” says Rebetez.
Value: Value ETFs screen for stocks with low price earnings, a low price-to-book ratio and/or a low price-to-cash-flow ratio, aiming to buy stocks when they are “on sale.” However, a low price could also indicate a stock whose heyday has come and gone. A properly screened value ETF filters out the has-beens.
Small-cap: Typically, smaller-cap stocks are expected to reward investors with greater gains over the long haul. “Not every small company will become a big company; there will be a few that will become massive companies and if you are there for that, you are going to enjoy it,” says Rebetez.
Active management: While active management may seem counterintuitive in a product category built on passive investing, this type of ETF can deliver portfolio manager expertise, often in specialized segments of the market.
Quality: This type of ETF aims to provide investors with a selection of holdings characterized by higher returns on equity, lower debt-to-equity ratios and greater stability in earnings than their peers.
“All of these approaches can, at times, be more in favour or less in favour,” says Rebetez. “But they introduce a disciplined way of refreshing the underlying exposure – removing what is no longer desirable and including what is becoming desirable.”
Smart beta ETF fees are more expensive than those of traditional market-cap-weighted ETFs, but are a fraction of the price of an actively trading portfolio manager, says Gordon.
“The goal for any portfolio is to get as much return as you can with as little risk as possible,” he adds. “These ETFs may add long-term outperformance while lowering overall volatility of returns.”
Susan Yellin specializes in investment management and insurance industry reporting, communications and public relations.
View full report online at etfworldmagazine.ca