{"id":11912,"date":"2014-05-21T17:35:54","date_gmt":"2014-05-21T09:35:54","guid":{"rendered":"https:\/\/canadianinquirer.net\/v1\/?p=11912"},"modified":"2014-05-25T17:41:39","modified_gmt":"2014-05-25T09:41:39","slug":"understanding-smart-beta-etfs","status":"publish","type":"post","link":"https:\/\/canadianinquirer.net\/v1\/2014\/05\/21\/understanding-smart-beta-etfs\/","title":{"rendered":"Understanding \u2018smart beta\u2019 ETFs"},"content":{"rendered":"
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ShutterStock image<\/figcaption><\/figure>\n

\u201cSmart beta\u201d is far from a new idea, but in the world of exchange traded funds\u00a0(ETFs), it is the latest buzzword. The industry is slowly moving away from\u00a0offering passive strategies alone to providing semi-active or rules-based strategies\u00a0as alternatives to the traditional market capitalization-weighted index strategies\u00a0that have made ETFs so popular. These new approaches seek to outperform the\u00a0market or manage risk, and have come to be known broadly as \u201csmart beta\u201d funds.<\/p>\n

Here\u2019s a look at how they work and some of the strategies they use.<\/p>\n

What is smart beta?<\/strong><\/p>\n

Smart beta has come to represent an alternative to broad market exposure by\u00a0focusing on single or multiple non-market factors.<\/p>\n

In the financial jargon, \u201cbeta\u201d is most commonly used to represent sensitivity to\u00a0market movements. In fact, beta can represent sensitivity to many other factors,\u00a0including volatility, momentum, or company-specific fundamentals such as\u00a0dividends, revenue, or price-to-earnings ratios.<\/p>\n

Another aspect of smart beta strategies is the weighting scheme used. While a\u00a0traditional index may assign holdings\u2019 weights based on the market capitalization\u00a0of the individual holdings, a smart beta index assigns weights based on other\u00a0factors. So if, for example, the index factor is dividend payout, a larger weight will\u00a0be assigned to the highest dividend payer in the pool. By assigning weights based\u00a0on these factors, beta strategies focus on the economic drivers or the characteristics\u00a0of the ETF\u2019s underlying holdings rather than the market size.<\/p>\n

Many of the smart beta indices are derived from the traditional market\u00a0capitalization-weighted index. The smart beta version uses the pool of holdings\u00a0from the same index to apply a rules-based methodology. For instance, iShares\u00a0MSCI EAFE Minimum Volatility Index Fund (TSX: XMI) is the smart beta\u00a0version of the iShares MSCI EAFE Index Fund (TSX: XIN). The former gives\u00a0higher allocation to lower volatility international equity stocks drawn from the\u00a0MSCI EAFE index.<\/p>\n

Smart beta may lead\u2026 or lag<\/strong><\/p>\n

Although investors expect smart beta strategies to outperform the market,\u00a0depending on the market conditions, the smart beta might lead or lag the traditional\u00a0market index. By definition, riskier factors should be rewarded with higher returns;\u00a0however, this is not always true.<\/p>\n

Here is case in point. Low volatility became a very popular strategy in 2012 as\u00a0investors sought to manage risk exposure while gaining from upsides in equity\u00a0markets. A good number of low-volatility ETF products were created, and the\u00a0strategy attracted a big inflow of money. Given their lower risk, the strategy was\u00a0supposed to lag the counterpart, but it did not. As in any other market, demand and\u00a0supply also play a role in determining prices.<\/p>\n

Smart beta strategies<\/strong><\/p>\n

Here are some examples for the most common smart beta strategies in the\u00a0Canadian and U.S. ETF space.<\/p>\n

Dividend.<\/strong> Some smart beta strategies focus on fundamentals, including dividend\u00a0policy and sustainability over the long term. For example, RBC recently launched\u00a0its Quant Dividend lineup, a rules-based, multi-factor strategy that offers investors\u00a0geographic exposure. Offerings include the RBC Quant Canadian Dividend\u00a0Leaders ETF (TSX: RCD), RBC Quant U.S. Dividend Leaders ETF (TSX: RUD)\u00a0, and RBC Quant EAFE Dividend Leaders ETF (TSX: RID). These ETFs offer\u00a0exposure to Canadian, U.S., and EAFE markets while targeting companies with\u00a0strong balance sheets and the potential for dividend growth.<\/p>\n

Fundamental.<\/strong> Fundamental-weighted indices include factors such as company\u00a0revenue, cash flow, and book value among others. For example, Invesco\u00a0PowerShares offers ETFs that follow the FTSE RAFI family of fundamental\u00a0indices. The FTSE RAFI methodology has been adopted by PowerShares FTSE\u00a0RAFI Canadian Fundamental ETF (TSX: PXC) in the Canadian market and by\u00a0PowerShares FTSE RAFI U.S. 1000 Portfolio ETF (NYSE: PRF) in the U.S.<\/p>\n

Momentum.<\/strong> A momentum strategy uses the recent price performance of a stock\u00a0to assign a momentum score. The idea behind a momentum strategy is to hold the\u00a0stocks with the best return over the previous few months. For example, First Asset\u00a0incorporates the momentum strategy in two of their ETF offerings with exposure to\u00a0the Canadian and U.S. markets. First Asset Morningstar Canada Momentum Index\u00a0(TSX: WXM) and First Asset Morningstar U.S. Momentum Index ETF (TSX:\u00a0YXM) seek to replicate the Morningstar\u2019s momentum indices, which incorporate\u00a0both price and earnings momentum.<\/p>\n

Earnings quality.<\/strong> An earnings-quality strategy looks at growth and leverage\u00a0factors among others to target companies with growing earnings and financial\u00a0soundness. U.S. based Market Vectors MSCI International Quality ETF (NYSE:\u00a0QXUS) and Market Vectors MSCI Emerging Markets Quality ETF (NYSE: QEM)\u00a0target international and emerging market companies with a high return on equity\u00a0(ROE), stable annual earnings growth, and low financial leverage.<\/p>\n

Minimum volatility.<\/strong> This strategy typically seeks to minimize the variance of the\u00a0portfolio by giving higher allocations to the stocks with lower risk as measured\u00a0by standard deviation. For example, the PowerShares S&P\/TSX Composite Low\u00a0Volatility Index ETF (TSX: TLV) seeks to replicate the performance of the S&P\/TSX Composite Low Volatility Index, which tracks the 50 stocks with lowest\u00a0volatility over the previous 252 trading days.<\/p>\n

Some volatility strategies use \u201cbeta\u201d instead, because it measures the stock\u00a0sensitivity to market movements. With exposure to the U.S. equity market, BMO\u00a0Low Volatility U.S. Equity ETF (US Dollar Units) (TSX: ZLU.U) is a good\u00a0example of a strategy that assigns higher weights to securities with lower betas.<\/p>\n

Courtesy of Fundata Canada Inc. \u00a9 2014. Maria Fernanda Parra is Senior\u00a0Analyst, Analytics & Data, at Fundata Canada Inc. Investments mentioned are not guaranteed and carry risk of\u00a0loss.<\/em><\/p>\n","protected":false},"excerpt":{"rendered":"

\u201cSmart beta\u201d is far from a new idea, but in the world of exchange traded funds\u00a0(ETFs), it is the latest …<\/p>\n","protected":false},"author":44,"featured_media":11913,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[19],"tags":[3990,3991,3992],"class_list":["post-11912","post","type-post","status-publish","format-standard","has-post-thumbnail","category-business","tag-etf","tag-exchange-traded-funds","tag-smart-beta","mauthors-maria-fernanda-parra","mauthors-fund-library-newswire"],"_links":{"self":[{"href":"https:\/\/canadianinquirer.net\/v1\/wp-json\/wp\/v2\/posts\/11912","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/canadianinquirer.net\/v1\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/canadianinquirer.net\/v1\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/canadianinquirer.net\/v1\/wp-json\/wp\/v2\/users\/44"}],"replies":[{"embeddable":true,"href":"https:\/\/canadianinquirer.net\/v1\/wp-json\/wp\/v2\/comments?post=11912"}],"version-history":[{"count":0,"href":"https:\/\/canadianinquirer.net\/v1\/wp-json\/wp\/v2\/posts\/11912\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/canadianinquirer.net\/v1\/wp-json\/wp\/v2\/media\/11913"}],"wp:attachment":[{"href":"https:\/\/canadianinquirer.net\/v1\/wp-json\/wp\/v2\/media?parent=11912"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/canadianinquirer.net\/v1\/wp-json\/wp\/v2\/categories?post=11912"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/canadianinquirer.net\/v1\/wp-json\/wp\/v2\/tags?post=11912"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}