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‘Smart beta’ is a term you might not have heard about but are likely to hear mentioned a lot in the near future — and not just in this column.

It’s a relatively new investment strategy that has been a buzz word among the pros in the industry for the last decade.

What’s in a name?


With ‘smart beta’ the name says it all. Beta is professional investment jargon that refers to a measure of risk. Beta is expressed as a number in comparison to baseline investment, like the TSX Composite Index. “Beta is the sensitivity of a stock to the overall market,” says Bob Stammers with the CFA Institute. “The beta to the S&P 500 is ‘1’ if you own an index fund that mimics its performance.” So a mutual fund with beta of higher than one, for example, would be highly correlated to the market, only possibly more volatile and risky. An investment with a beta less than one is less correlated to the market and hence considered less volatile and risky. With regard to ‘smart beta’, the idea is you’re investing in something that provides you with ‘beta’—that is it passively tracks an index like the TSX Composite—but it uses strategies to reduce the risk associated with the index while supposedly enhancing returns. “Smart beta is a marketing phrase referring to getting exposure to the market, but finding better ways to do it,” says Som Seif with Purpose Investments.


Stretching the boundaries of smart beta:

Claymore Investments was a Canadian pioneer in low-fee exchange traded funds (ETFs), and it was also one of the first to offer funds that didn’t just emulate an index like the TSX Composite Index. Its lineup of ETFs included some of the first fundamental index funds, weighting companies using metrics—like book value, cash flow and dividends.

The founder of Claymore’s Canadian arm, Seif has since moved on to launch Purpose Investments, which he contends takes the ‘smart beta’ idea a few steps further. “We’re marrying really intelligent discipline investment processes—everything is based on rules that are systematic—but we’ve also over-laid things like risk management.” The company launched its fleet of ETFs last year and now has $500 million under management. It recently introduced two new ETFs that Seif argues are at the vanguard of a new generation of low-cost, diversified investments that reduce risk associated with traditional passive investment strategies.


One is the Purpose Best Ideas Fund, an ETF that invests in about 25 securities — all of which are the top holdings of some of the world’s best value and activist investors. “What we’re focused on is their best and most concentrated investment ideas,” Seif says about money managers like George Soros, Bill Ackman and David Einhorn. “What that means is each company in the fund is held broadly, not just by one manager, but by multiple managers.”


The other fund is Purpose Duration Hedged Real Estate Fund, which holds top North American real estate firms listed on stock exchanges, but it hedges the risk of interest rate hikes that can negatively affect real estate. When necessary, the ETF managers can short — bet against — 10-year government bonds, which can help reduce the impact of rising rates on real estate assets, he says.

And for the do-it-yourself investor, or someone who works with an adviser, ‘smart-beta’ products may be worth a closer look.

Smart beta refers to a strategy that brings together the best of active and passive management styles.

Active management strategies generally involve mutual funds in which money managers pick stocks to hold in a portfolio based on each investment’s merit. In turn, investors pay fees annually — the management expense ratio (MER) — in exchange for this expertise. Good fund managers’ funds outperform their benchmarks — such as the TSX Composite Index or the S&P 500 — more years than not.

The chief criticism of active management has been the high fees investors pay (generally between two and three per cent a year) are a drag on performance, meaning even well-managed funds can have difficulty beating their benchmark indices consistently over time.

Passive management, in contrast, simply aims to emulate the benchmark, so a fund will hold, for example, the top 60 companies on the TSX and track their performance. Whatever their performance is in any given year is the return on the fund. The advantage of passive management is you’re not trying to beat the index. You just want its performance, and you’re not paying a high fee for management to do it.

The knock against it has always been passive investment products — mostly exchange traded funds (ETFs) — are built using a technique called market weighting or capitalization weighting.

"The problem with conventional indexing — capitalization weighting — is the more expensive a company is, the bigger its weight is in your portfolio," said Rob Arnott, CEO of Research Affiliates, a Newport Beach, Calif.-based investment research firm and pioneer of smart beta strategies.

With passive index investing, you’re always buying a market-capitalization-weighted index so the largest holdings in that collection of stocks will always be those companies with the highest share prices.

This isn’t inherently a bad thing. Companies can be priced highly because they’re good businesses. Yet, passive index investing can be problematic because capitalization weighting leads to being heavily invested in high-priced companies with grim futures, poised for a swan dive. Most Canadian investors are well aware of some vivid examples of this: Nortel and Research in Motion, aka BlackBerry. Both tech companies were once darlings of Canada’s stock market with stock prices exceeding $100, and they made up a substantial portion of the TSX.

If you owned a fund that emulated the TSX index, a significant portion of your money would be invested in these firms by default, which would act as a drag on the fund’s performance as their stock prices collapsed.

Smart beta strategies evolved out of a need to address this problem. Its proponents believe index investing remains an effective way to build wealth because it is low-cost, with MERs less than one per cent of assets per year. Rather than using market capitalization weighting, which is what is used to build indices like the Dow Jones Industrial Average, TSX, S&P 500 and NASDAQ, to name a few, a different metric is used.

The most common smart beta products on the market today called ‘fundamental index,’ a concept developed by Research Affiliates about a decade ago, use a variety of metrics to weight stocks such as book value, revenues, dividends, sales and cash flows.

"Back in 2004 and 2005, we introduced the idea of fundamental index, which instead of weighting companies by market capitalization — how large the value is the market places on a company — we weighted companies by their economic footprint," Arnott said. "How big is their actual business?"

This is very similar to an active strategy called value investing, made popular by successful investors like Warren Buffett, which favours companies with good business prospects that aren’t reflected in their share price. In other words, the market undervalues them.

"Early critics were correct in saying it (smart beta) is really just a value-tilted portfolio, because what it does is take the value stocks and raises them up to their economic footprint and with the growth stocks, it reduces them to their actual economic footprint," he said.

"Since we’ve introduced the idea — we now have nine years of live track record — fundamental index has won by about two per cent per year (compared to benchmark indices) all over the world during a time when value stocks have been underperforming."

Today, fundamental-index-style ETFs are commonplace. Research Affiliates licenses its concept to investment firms around the world, including those offering product in the Canadian market like iShares.

"We’ve gone from nothing in 2004 for fundamental index to $125 billion today," he said. "On the one hand, that’s tremendous growth, and on the other, it’s a tiny fraction of the total market, so this idea still has a lot of room to grow."

It has also inspired other firms to develop many other kinds of smart beta, like minimum variance style indexing that tracks only stocks with low volatility, meaning they don’t swing wildly up and down in price.

Yet its critics contend smart beta has become as much of marketing ploy to attract investors as it is a viable portfolio strategy, and an endless array of products is being rolled out for better and for worse.

"When someone says ‘smart beta’ it’s really a question of what they’re actually talking about because there are so many different ways of doing this and so many different products," said Bob Stammers, director of investor education at the CFA (Chartered Financial Analysts) Institute in New York.

"Anything that’s not capitalization weighted is now being put in the smart beta bucket."

While investors avoid the risks associated with traditional index investing — like owning too much of a Nortel-type company — they can find themselves exposed to other risks.

For example, a smart beta ETF that focuses on low volatility stocks could concentrate too much on one particular sector like utilities.

Yet smart beta is constantly evolving and really mirrors growing demand for low-cost ETFs, says Som Seif, the founder of Canadian arm of Claymore Investments, one of the first Canadian firms to offer smart beta ETFs, that was eventually sold to iShares’ owner Black Rock a few years ago.

"You want to keep costs low, but you also want somewhat intelligent strategies as to how you would actually weight and select the companies in the portfolio," said Seif, now CEO of another ETF innovator in Canada called Purpose Investments.

"That’s what smart beta should be, but the problem is that everyone throws a bunch of crap out there into the marketplace and what has happened in the last couple of years as this has grown is there are a lot of crappy products and some quite good ones."

For many investors, that puts them back at square one regarding their biggest challenge developing a portfolio: picking the right investments.

Although smart beta products can be part of the solution, Stammers says it’s not a panacea strategy.

"As far as we’re concerned smart beta strategies should be simple, low-cost, transparent and rules-based," he said. "It’s the hot thing right now and it’s been marketed widely, but just like anything else, you need to understand what you’re investing in."

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