Un­lock­ing the po­ten­tial of smart beta for your clients

Smart beta: a pow­er­ful tool to meet spe­cific client ob­jec­tives

Investment Executive - - BRAND KNOWLEDGE -

With mar­kets at all-time highs, clients are look­ing for an al­ter­na­tive source of re­turn and risk man­age­ment. “Smart beta” has be­come a pop­u­lar in­vest­ing strat­egy to help achieve these client ob­jec­tives. What is smart beta? “It’s an in­dex con­struc­tion method­ol­ogy that is dif­fer­ent from a tra­di­tional mar­ket-cap­i­tal­iza­tion weight­ing,” says McKen­zie Box, Se­nior Prod­uct Man­ager at BMO Global As­set Man­age­ment (BMO GAM). “It could in­clude a strat­egy such as equal weight­ing, or more com­plex strate­gies fo­cused on a spe­cific mar­ket fac­tor such as value, qual­ity or in­come.” Smart beta has been used suc­cess­fully by in­sti­tu­tional in­vestors for years. Now, through ex­change-traded funds (ETFs), re­tail in­vestors can ef­fi­ciently ac­cess these in­sti­tu­tional-like strate­gies to ad­just their port­fo­lios. In­vestors have em­braced the emer­gence of smart beta, cap­i­tal­iz­ing on the op­por­tu­nity to build port­fo­lios based on iso­lated char­ac­ter­is­tics, to change the risk pro­file of a port­fo­lio, or to com­ple­ment an ex­ist­ing mar­ket-cap­i­tal­iza­tion weighted ETF.

Smart beta al­lows clients to tar­get spe­cific fac­tors

In­sti­tu­tions have been us­ing smart beta so­lu­tions for some time, but now ETFs have made these strate­gies more ac­ces­si­ble to both in­sti­tu­tional and re­tail clients. Aca­demic stud­ies have shown that, his­tor­i­cally, cer­tain fac­tors have con­sis­tently added value over the long term, es­pe­cially on a risk-ad­justed ba­sis. To­day, some of the most widely used fac­tor-based ETFs in smart beta in­vest­ing in­clude:


• Value in­vest­ing is the pur­suit of low-cost se­cu­ri­ties rel­a­tive to their in­trin­sic value. At BMO GAM, fac­tor-based value in­vest­ing tar­gets a con­cen­trated seg­ment of an in­vestable uni­verse and iden­ti­fies in­vest­ment op­por­tu­ni­ties through eval­u­at­ing met­rics such as low price-to-book, and higher div­i­dend yield met­rics.


• A qual­ity in­vest­ing strat­egy iden­ti­fies com­pa­nies with strong, long-term fun­da­men­tals. High-qual­ity firms have com­pet­i­tive ad­van­tages and durable busi­ness mod­els, so qual­ity fac­tors in­clude high re­turn on eq­uity, sta­ble year-over-year earn­ings growth and low fi­nan­cial lever­age. Iden­ti­fy­ing these fac­tors helps BMO GAM’s qual­ity ETF strat­egy to avoid in­ex­pen­sive stocks mas­querad­ing as bar­gains.


• A low-volatil­ity strat­egy aims to par­tic­i­pate in mar­ket growth with po­ten­tially less risk. By se­lect­ing se­cu­ri­ties that ex­hibit lower risk rel­a­tive to the broad mar­ket, a low-volatil­ity strat­egy can soften the im­pact of mar­ket de­clines, help­ing the pos­i­tive re­turns of a port­fo­lio com­pound more ef­fec­tively over the long run.


• High div­i­dend in­vest­ing iden­ti­fies high­yield­ing, div­i­dend-pay­ing eq­ui­ties. BMO, for ex­am­ple, em­ploys a cus­tom strat­egy that screens for a div­i­dends his­tor­i­cal growth rate and long-term sus­tain­abil­ity. This longterm strat­egy is a so­lu­tion to ad­dress a client’s in­come gap and need for lower port­fo­lio risk.


• Small-cap stocks tend to out­per­form large­cap stocks over the long term. Yet, con­ven­tional mar­ket-cap weight­ing strate­gies nat­u­rally as­sign a greater weight­ing to larger com­pany stocks. An equal-weight method­ol­ogy how­ever, gives equal weight­ing to all stocks in a fund, re­gard­less of mar­ket cap, al­low­ing the port­fo­lio to prop­erly di­ver­sify sec­tor ex­po­sures and to avoid in­di­vid­ual se­cu­rity con­cen­tra­tion.

It should be noted that fac­tor-based in­vest­ing can be used as core po­si­tions in your port­fo­lio or can com­ple­ment us­ing tac­ti­cal strate­gies. Dur­ing cer­tain points in the eco­nomic cy­cle, dif­fer­ent fac­tors may out­per­form oth­ers. Smart beta ETFs can de­liver ex­po­sure to a de­sired fac­tor and give an in­vestor the abil­ity to ro­tate into and out of these fac­tor ex­po­sures ef­fi­ciently to re­flect mar­ket sen­ti­ment.

The best of ac­tive and pas­sive in­vest­ing

The evo­lu­tion of the ETF in­dus­try has em­pow­ered in­vestors with a new toolkit to im­ple­ment these strate­gies ef­fi­ciently and cost ef­fec­tively. ETFs have moved be­yond tra­di­tional ex­po­sures, giv­ing clients more tools to build port­fo­lios whether they are look­ing for higher yields, lower risk, or tar­geted fac­tor ex­po­sures. In turn, smart beta so­lu­tions have given in­vestors greater choice in terms of se­lect­ing a fac­tor based on ex­po­sure and ge­og­ra­phy. Smart beta ETFs com­bine the best of ac­tive and pas­sive in­vest­ing, bridg­ing the gap be­tween the two worlds. Based on your clients’ ob­jec­tives, you can help them tilt their port­fo­lios in favour of spe­cific fac­tors. At the same time, clients can also en­joy the ben­e­fits of pas­sive in­vest­ing, in­clud­ing: 1) LOW COST 2) TRANS­PARENCY 3) RULES-BASED AP­PROACH

To avoid bi­ases, look un­der the hood

As smart beta has evolved, port­fo­lios have moved be­yond sin­gle fac­tor lenses. Ef­fec­tive strate­gies are now in­creas­ingly screen­ing for mul­ti­ple fac­tors and mon­i­tor­ing for un­in­tended bi­ases such as sec­tor or in­dus­try con­cen­tra­tion, or even ex­cess turnover. Clients should al­ways se­lect an ETF provider with ex­pe­ri­ence in prod­uct con­struc­tion and risk man­age­ment. Well-de­signed smart beta ETFs can help avoid un­in­tended bi­ases. “These bi­ases are un­wanted ex­po­sures that can be­come present when you’re iso­lat­ing for a par­tic­u­lar fac­tor,” says Box.

Con­sider a smart beta ETF that uses div­i­dend yield as the weight­ing met­ric. A stock whose div­i­dend yield ap­pears at­trac­tive be­cause its share price has dropped sig­nif­i­cantly (for rea­sons like a neg­a­tive earn­ings sur­prise, for ex­am­ple) would have a higher weight in the ETF. While the pay­out may not be sus­tain­able, the stock is still in­cluded in the ETF be­cause the se­lec­tion rules failed to ac­count for fun­da­men­tal com­pany changes.

Con­sider that same port­fo­lio where a high con­cen­tra­tion of fi­nan­cial stocks may pass the screens. BMO ETFs ap­ply sec­tor and se­cu­rity lim­its to en­sure a well-di­ver­si­fied port­fo­lio. Af­ter all, if clients want a bank or fi­nan­cial ETF those are avail­able as well.

A well-con­structed smart beta ETF has more than one defin­ing met­ric and nu­mer­ous built-in risk con­trols. For ex­am­ple, BMO Global As­set Man­age­ment has cre­ated a cus­tom so­lu­tion to iden­tify higher yield­ing div­i­dend-pay­ing eq­ui­ties, while screen­ing for both the his­tor­i­cal growth rate and sus­tain­abil­ity of div­i­dends.

One thing is clear: Smart beta is not a fad. “We’re see­ing more multi-fac­tor prod­ucts come to mar­ket com­bin­ing two dif­fer­ent fac­tors in one so­lu­tion,” says Box. “We ex­pect to see more in­no­va­tive smart beta fixed in­come prod­ucts come to mar­ket as well.” Over­all, the fu­ture for smart beta strate­gies looks bright. Through the end of De­cem­ber 2017, global ETF as­sets in smart beta strate­gies to­taled a record US$658 bil­lion, and the five-year com­pounded an­nual growth rate stood at 32.2%.


Source: BMO Global As­set Man­age­ment

McKen­zie Box Se­nior Prod­uct Man­ager BMO Global As­set Man­age­ment

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