“This is a reprint of The Globe and Mail article published on February 10, 2020."
‘Smart beta’ has emerged as the next stage of advancement for investors and financial advisors interested in diversified, low-cost equity exchange-traded funds (ETFs), which have performed swimmingly well during the past decade thanks to the U.S. bull market’s rising tide.
Smart beta ETFs screen investments for factors beyond market-capitalization weightings associated with traditional ETFs – and they’re becoming increasingly popular.
According to ETF.com, more than 1,000 smart beta ETFs now trade on North American stock markets, including 95 that were launched last year. Investors have poured more than $1-trillion into the category.
Todd Mathias, certified financial analyst, vice-president–senior ETF product strategist at Franklin Templeton in San Mateo, Calif., says their popularity is driven in part by investment advisors, who are increasingly wary of clients’ overexposure to broad-based indexes like the S&P 500.
“Many [advisors] tell me they have been worried about this for a few years, and it only becomes more top of mind when you look at the current multiples [in stock prices],” he says.
Thus, advisors are looking to smart beta strategies as a way to moderate risk while providing some form of protection if the market reverses quickly.
“Smart beta rewrites the traditional index rulebook, which weights and invests by the size of the company’s security,” Mr. Mathias says.
In contrast, smart beta’s factor-based index approach employs research-driven strategies to screen stocks for an ETF portfolio.
Typically, these screens encompass one of five strategies: quality (companies with good earnings growth), value (firms that are undervalued), momentum (stocks that have stronger recent price appreciation), low volatility (companies with lower risk than the market) and dividend (those firms paying out higher dividends than average).
In the past couple of years, the low-volatility subcategory has been especially popular, says Daniel Straus, vice-president of ETFs and financial products research at National Bank of Canada Financial Inc.
“We’ve seen waves of inflows into this class of ETFs,” he says. “Every time, they prove their mettle by outperforming during periods of higher market volatility.”
In the past couple of years, the low-volatility subcategory has been especially popular, according to National Bank of Canada Financial Inc., which tracks ETFs.
The firm reports it has seen waves of inflows into smart beta ETFs. In 2019 alone, low-volatility ETFs attracted $2.5-billion in Canada, and much of this inflow came in the aftermath of the U.S. market selloff in late 2018.
Mr. Mathias points to the past year as an example. In the first six months of 2019, a low-volatility smart beta ETF would have outperformed the market. The second half of the year was a different story, though, with the strategy lagging behind the S&P 500 by about 8 per cent.
Due to the cyclical nature of each smart beta strategy, investors face the challenge of selecting the right factor to not only match current market conditions but future ones, too. Essentially, advisors run the risk of picking the wrong ETF at the wrong time.
The industry has moved to address this by creating multi-factor smart beta ETFs.
Mr. Mathias says these multi-factor ETF strategies essentially give investors another layer of diversification, providing exposure to several factors at once in one low-cost, liquid portfolio.
“By combining these factors thoughtfully, you can enhance returns and reduce risk, while still keeping clients invested in equity markets,” he says.
Mr. Mathias says Franklin Templeton offers four multi-factor ETFs in its suite of ETFs in Canada.. Among them is Franklin LibertyQT U.S. Equity Index ETF (FLUS), which has attracted more than $240-million in client assets since its 2017 launch in Canada.
FLUS utilizes a rules-based approach to select U.S. stocks, which have favourable exposure to four factors and strategically weighted: quality at 50 per cent, value at 30 per cent, momentum at 10 per cent and low volatility also at 10 per cent.
Mr. Mathias says Franklin Templeton’s smart betaofferings are not designed to capture all the upside of the broader markets. Rather multi-factor ETFs seek to mitigate downside risk while capturing a substantial portion of the upside in the market.
This emphasis on quality resonates with many advisors, he adds. Among them is Azeem Virjee, senior investment advisor and portfolio manager at Wellington-Altus Private Wealth Inc. in Calgary, who says “traditional portfolio construction” presents challenges because “market capitalization is based on two key assumptions:” markets are efficient and investors are rational. “In reality, [neither] is often not the case.”
Mr. Virjee adds that a single-beta approach, while useful at times, is not as desirable as a multi-factor ETF, which “helps smooth out returns” over time.
By design, multi-factor ETFs reduce the depth of market dips, which in turn helps keep clients happy, Mr. Mathias says.
“The strategy is basically saying, ‘I believe value, quality, momentum and low volatility are strategies worth investing in, but I don’t want to be on the wrong side with a strategy losing money one to two years,’” he explains. “So, by blending all these factors together in one product, I’m getting the best of all worlds.”
Jeremy Olen, chief investment officer at The Financial Services Network in Sacramento, Calif., which provides investing and portfolio consulting services to independent advisors, points out that multi-factor ETFs are ideal for expressing long-term market views in a client portfolio “in a low-cost, tax efficient manner.”
They often have low management expense ratios and because they offer exposure to several factors, advisors don’t have to trade in and out of single-factor ETFs to adjust to market conditions, which would otherwise increase trading costs and potentially lead to realized, taxable capital gains, he says.
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