Skip to main content
exchange-traded funds: smart beta

Som Seif, chief executive officer of Toronto-based Purpose Investments Inc.: Ask questions. What’s the fund strategy, how does it make money?Della Rollins/The Globe and Mail

Between $373-billion and $500-billion (U.S.) is sloshing around in smart beta exchange-traded funds globally – depending on how you define smart beta. This is an increase of more than 30 per cent in the past five years, according to one British expert, who feels the world's understanding of the hybrid index funds has not kept pace.

"Smart beta is still a term that doesn't have an agreed definition," says Deborah Fuhr, partner at Britain-based ETFGI LLP. Her company researches and consults on a database of more than 5,000 exchange-traded products around the world with assets topping $2-trillion (U.S.). She considers 809 of those ETFs to be smart beta, but acknowledges that others might not. "The index providers do not agree among themselves on which factors are smart and which are not. They also do not agree on how they are calculated," she says.

Smart beta is a broad term for ETFs that go beyond simply tracking an index. Traditional ETFs track market-weighted indexes, such as the S&P 500, directly by attempting to purchase the same companies according to their current market value. As those values – or weightings – change, the ETF will purchase more or less accordingly. If the index rises 10 per cent, for example, the ETF should rise proportionally minus an annual fee that is usually about 10 basis points (one-tenth of a per cent).

Smart beta ETFs, on the other hand, go beyond the index by using other factors such as equal weighting where every company in an index has the same value. Other smart beta strategies seek to minimize volatility or focus on criteria more closely tied to the economic fundamentals behind a country or sector. And then there are the ETFs that fall somewhere in between. "There are products that are not market cap and are not smart beta," Ms. Fuhr says.

Other smart beta methodologies include fundamental factors for selecting companies in an ETF such as sales, cash flow, book value or dividends. "So many of the products that would be identified as being smart beta would be products that are factor-based," she says. "Many are now developing multifactor products where you would see less variability in the performance."

She says the smart beta trend has been toward companies that pay out dividends. "Dividend-focused products account for 33 per cent of all the assets in what we would define as smart beta, equity type products," she says.

With so many strategies and so many smart beta ETFs in their infancy she says performance is hard to gauge. "Over long time periods these factors should outperform market cap, but there could be many years of underperformance."

As an example, one multifactor smart beta ETF is the John Hancock Multifactor Large Cap ETF (JHML). Fund managers select U.S. large cap stocks emphasizing factors such as size, how the stock price compares to its peers and profitability. According to the prospectus, investment decisions are based on academic research that has linked them to higher expected returns. The top holdings are Apple Inc. and Microsoft Corp.

Since its launch on the New York Stock Exchange in September, the John Hancock MultiFactor ETF has returned about 9 per cent, compared with about a 10-per-cent advance for the broader S&P 500 over the same period.

Another example of one of the few smart beta dividend ETFs that trade on the Toronto Stock Exchange is the iShares Canadian Select Dividend Index ETF (XDV). It tracks 30 of the highest yielding, dividend-paying companies in the Dow Jones Canada Total Market Index using a rules-based methodology including an analysis of dividend growth, yield and average payout ratio. The big Canadian banks dominate the fund's holdings.

Since its inception in December of 2005 it has gained about 9 per cent in value compared with the broader S&P/TSX Composite, which has advanced about 25 per cent.

"I think it's the worst terminology in the world. I don't like the concept of what they call smart beta," says Som Seif, a Canadian ETF pioneer and chief executive officer of Toronto-based Purpose Investments Inc.

He prefers the term "factor investing." "They are factors that make potential opportunities to beat the market," he says. "They're using certain rules to overweight or underweight those factors."

Mr. Seif agrees that smart beta, or factor investing, is in its early stages and has yet to be proven. "There's no question it's growing. … There are great products being developed, but there are also a lot of products that have challenges."

His advice to investors looking to delve into the world of smart beta investing is to do their homework and try to time it right. "Dig in and ask questions: What's the fund strategy, how does it make money?" he says. "One thing that is very important about factor investing is there will be times when those factors are in favour, and there are times when they are out of favour."

He also tells investors to be patient or risk getting out in a time of volatility and locking in losses. "If you have the patience to stick around through that, it's great. If you don't, it's a bad thing."

As smart beta ETFs become more complex, the cost of managing them rises. One of the biggest appeals of ETFs is their relatively low cost compared with mutual funds, which usually charge annual fees between 2 and 3 per cent. But even as ETFs move from passive to active management, they can still maintain a cost edge, Mr. Seif says.

"You're getting what most active money managers are providing, but instead of 1 per cent you're getting it for 50 or 60 basis points, which is a really big positive."

Interact with The Globe