The many breeds of beta

Christopher Davis: Perhaps the best way to define smart beta or strategic beta as we call it is to first talk about what it's not. If you look at conventional indexes like the S&P 500 or the TSX Composite, these are pure beta strategies. They provide broad market exposure and that’s pretty much it. For the longest time, this is how we’ve defined beta. Strategic beta, or smart beta, as many market practioners like to call it, do something different. They attempt to improve the returns to the market-cap-weighted index, at least once you account for risks.

Strategic beta can fall in a lot of different kinds of buckets. These are things that active managers have been doing for a long time. Strategic beta strategies will do the same thing, such as overweighting value stocks, overweighting stocks that exhibit positive momentum, screen for stocks that are paying dividends. Strategic beta occupies that middle ground between active management and passive management. You get the elements of active management in the sense that you are making a bet against the overall market, but it tracks an index.

Value investing is the granddaddy of all investment factors. The value factor has been around for even longer than beta, let alone strategic beta. This is based on academic research demonstrating that cheaper stocks tend to outperform over the long haul, and this is true in virtually all markets all around the world. One example of an ETF employing this strategy in Canada is the iShares Canadian Value ETF, and what it does is it weight stocks by their valuation. It screens for stocks that trade cheaply on the basis of price-to-earnings and price-to-book and other types of valuation metrics.

The equal-weighted approach has been around for a while; again, one of those approaches that’s been around longer than strategic beta. As its name implies, instead of holding stocks in proportion to what the market says they are worth, an equal-weighted strategy will weight all of the underlying constituents of an index equally. So instead of having Apple as the largest holding in the S&P 500, Apple would be of the same size as a component maker of an iPhone, for instance. This is strategic beta strategy is twofold: One, it represents an alternative weighting from the market-cap-weighted index, but two, it aims to benefit from the size effect. The size effect is based on academic research, indicating that small company stocks tend to outperform larger ones over the long haul. Equal-weighted indexes inherently will weigh smaller stocks in greater proportion.

There aren’t a whole lot of ETFs in Canada that tap into the strategy. Many of them tend to be sector ETFs. One example is the BMO S&P/TSX Equal Weight Banks ETF, which essentially holds all of the big five Canadian banks in equal proportion.

Dividend-screened strategies are by far the most popular of all of the strategic beta approaches in the Canadian market, [which is] not terribly surprising. This is a really popular class of mutual funds as well. As you might surmise by their name, dividend-oriented or dividend-screened strategic beta strategies incorporate dividends in some element of their process.

These come in two different varieties. One of them is exemplified by the iShares Core S&P/TSX Composite High Dividend ETF, and this ETF screens for the highest-yielding stocks in the Canadian market, so you have a portfolio that is chock-full of energy and financials names. The highest-paying dividend stocks often can be some of the riskiest. Yields are often high for a reason; investors really don’t believe that some of these companies will be able to maintain their dividends. So you have to tread cautiously with these types of strategies. Another approach is exemplified by the iShares S&P/TSX Canadian Dividend Aristocrats Index, which invests in companies that consistently increase their dividends. It's looking for companies that have increased their dividends for the past five consecutive years.

Now, dividend growth isn’t necessarily the same thing as yield. You could be growing your dividend pretty quickly and not be paying a lot in yield. But companies that can increase their dividends year-after-year tend to have relatively high returns on equity. They are highly profitable because they have the wherewithal to increase their dividends every year. So this is a way to hold some of the highest-quality firms with some of the strongest competitive advantages in the market, not necessarily a way to generate lots of income for your portfolio.

Low-volatility ETFs do what they say they would do: They screen for stocks that have some of the lowest volatility in the market. One example is the iShares MSCI Canadian Minimum Volatility Index. And here you are looking at some of the lowest volatility stocks in the Canadian market. They are weighted most heavily in this ETF. It's important to keep in mind that these stocks have historically low volatility; it doesn’t necessarily mean that such volatility will persist in the future. But the whole rationale for these strategies is that for a variety of possible reasons, lower volatility stocks have historically outperformed higher volatility stocks. Also, the academic research indicates that’s been the case, and in recent years it's been true for Canadian low volatility stocks. I think there should be some skepticism here; investors who think they are going to get outsized performance should tread carefully. But there is a decent chance that in many of these strategies, you'll get at least what's promised: lower than market volatility.

Instead of weighing companies by market cap, which is the conventional approach, fundamental weighted indexes will weight companies by their underlying fundamentals, such as sales growth, dividend growth, shareholder buybacks and other kinds of fundamental metrics which the originator of the fundamentally weighted strategies, Research Affiliates, uses as a better way to measure the true values of companies. In Canada, there are a handful of funds that track these strategies. One is the PowerShares FTSE RAFI Canadian Fundamental Index. These funds don’t explicitly try to play on the value factor, but they kind of do, because these portfolios tend to weight cheaper stocks.