Smart beta ETFs look to im­prove upon plain-vanilla in­dex funds

These ETFs are pro­jected to have as­sets of $1 tril­lion glob­ally by 2020

The Hamilton Spectator - - BUSINESS - CRAIG WONG

In­dex-track­ing ex­change-traded funds have be­come one of the fastest grow­ing ways for Cana­dian in­vestors to gain di­verse ex­po­sure to the stock mar­ket at a low price.

But now, smart beta ETFs are gain­ing ground as they look to im­prove on that by us­ing ad­di­tional cri­te­ria such as volatil­ity, val­u­a­tion, qual­ity and size to limit the stocks held in the fund.

“The prob­lem that they are try­ing to solve by us­ing smart beta is this idea that when you own all 500 com­pa­nies in the S&P 500, you know that in that mix there’s go­ing to be some that are just not great,” said Brent Van­der­meer, a port­fo­lio man­ager with Hol­lisWealth.

“The in­tent is try­ing to cre­ate a bas­ket that has bet­ter per­for­mance by fil­ter­ing out (com­pa­nies) based on cer­tain cri­te­ria … com­ing up with a smaller group and get­ting a bet­ter per­for­mance out of that smaller sub­set of stocks.”

The Toronto Stock Ex­change has about 500 ETFs listed with a to­tal mar­ket value of about $130 bil­lion.

Tra­di­tional bench­mark ETFs track an in­dex and those are weighted by mar­ket cap­i­tal­iza­tion, giv­ing the largest com­pa­nies in­cluded the big­gest in­flu­ence. That means if an ETF is track­ing the S&P/TSX com­pos­ite, it is heav­ily weighted to the fi­nan­cial, en­ergy and min­ing sec­tors.

Smart beta ETFs look to im­prove re­turns and re­duce risk by ap­ply­ing ad­di­tional rules to de­cide which com­pa­nies are in­cluded and which ones don’t make the cut. The rules are of­ten based on an ac­count­ing met­ric or a stock’s volatil­ity.

Van­der­meer, who uses ETFs in his clients’ port­fo­lios, says he uses smart beta depend­ing on the sit­u­a­tion.

“When we’ve wanted to de-risk the port­fo­lio, but stay in­vested in the mar­ket, we’ve used low-volatil­ity smart beta ETFs to re­duce our risk lev­els.”

He said they can also be used to com­ple­ment ac­tive man­age­ment.

Black­Rock’s iShares busi­ness, the world’s largest man­ager of ETFs, es­ti­mated last year that smart beta ETF as­sets will reach $1 tril­lion US glob­ally by 2020, grow­ing at a rate that is dou­ble the over­all ETF mar­ket.

Pat Chiefalo, head of iShares prod­uct at Black­Rock Canada, says ac­tive man­agers have tilted port­fo­lios to par­tic­u­lar kinds of stocks for years.

“What we have the abil­ity now is to do it in a very clear, rules-based method­ol­ogy and in­cor­po­rate it into an ETF and of­fer it at a bet­ter price point,” he said.

“So op­posed to now giv­ing you a plain-vanilla bench­mark that would typ­i­cally be mar­ket cap weighted, we can change that port­fo­lio and tilt that port­fo­lio to in­crease the weight­ing to value stocks or qual­ity stocks or div­i­dend stocks for that mat­ter.”

Chiefalo said it’s im­por­tant for in­vestors to un­der­stand what they are buy­ing and sug­gested smart beta funds may be for those who want to spend a lit­tle ex­tra time learn­ing the fac­tors used to con­struct the funds and how they work.

Smart beta op­tions also come at a cost. Chiefalo said the fees for smart beta are some­where in the mid­dle of the spec­trum, typ­i­cally more than other tra­di­tional low-cost ETF op­tions that track a given in­dex, but gen­er­ally less than an ac­tively man­aged fund.

Trad­ing in and out of smart beta ETFs could also boost your costs over a pas­sive in­vest­ment strat­egy and there is no guar­an­tee these types of funds will out­per­form the in­dex.

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