Is smart beta smarter?

This article was originally published in July 2012.

Alpha ain’t what it used to be.

People used to think alpha constituted about half of an institutional portfolio’s return (see “Evolution of beta”).Today, beta is credited with more than 75% of return.

Portfolio managers today are more focused on matching fund assets to their liabilities or achieving capital accumulation targets—and less interested in simply maximizing return.

One-third of institutions are using indexing. A Greenwich Associates global survey of 121 institutional investors from corporate, pension, and not-for-profit organizations—including eight Canadian funds—finds passive products already constitute 40% of their assets, with four-in-10 organizations expecting to be at that level by 2014.

Despite detractors, market-capitalization-weighted indexation (MCW) continues to dominate the passive equity space increasingly populated by ETFs. Critics say MCW exposes investors to overvalued stocks.

Supporters claim MCW reflects the current state of the market and all available information about it. Any other approach constitutes an active strategy with higher costs. Both positions are correct. This is little comfort to advisors looking to build portfolios for clients.

Evolution of beta

Source: MSCI

Indexing strategies exist on a spectrum, from MCW at one extreme to engineered beta at the other, says Northern Trust’s John Krieg. Alternative or “smart” beta approaches lie in between. But how smart are they?

Market-cap-weighted

These traditional indices are based on price or capitalization. Equities with a higher price or capitalization receive higher index weights. The assumption: markets are efficient, so all information is priced in. There is a cyclical bias to this approach because some components will be overvalued from time to time.

Although MCW indices represent the market, they may also have a large-cap growth bias (see “Market-capitalization-weighted equity ETFs”).

Market-capitalization-weighted equity ETFs

Market Cap-Weighted Equity ETFs: as at May 31, 2012	Symbol	Management fee	Assets $mil
iShares S&P/TSX 60 Index Fund	XIU	0.17%	$11,109
iShares S&P/TSX Capped Composite	XIC	0.25%	$1,224
BMO Dow Jones Canada Titans 60 Index9	ZCN	0.15%	$815
Horizon Betapro S&P/TSX 60*	HXT*	0.07%	$338
Vanguard MSCI Canada Index	VCE	0.09%	$47
Vanguard MSCI Emerging Markets	VEE	0.49%	$41
First Asset Morningstar National Bank Quebec	QXM	0.50%	$29

*Horizon Betapro’s HXT has a payoff related to the S&P/TSX 60 Index but is constructed using a swap to which default risk is associated.

Smart beta

Fundamental, equal-weighted, and GDP-weighted indices fall into this group. Fundamental approaches either weigh an issue’s fundamental characteristic (such as book value or revenue) or decouple index weight from prices like the RAFI series.

Fundamental indices and valuebased funds tend to outperform MCW at the same time, affirming a value bias. These are active tilts that can be used independently or in combination with other strategies. Higher rebalancing costs are usually involved.

Equal-weighted indices that are rebalanced monthly offer some performance advantage over value and MCW (according to Plyakha, Uppal and Vilkov, 2012). These indices sever the relationship between price and index weight.

This approach is contrarian—overvalued stocks can be significantly underweight from time to time. The benefit of equalweighted indices comes from the rebalancing frequency, meaning higher transaction costs. Performance is also tied to the nature of the index. In Canada, this suggests a small-cap bias (see “Smart beta equity ETFs”).

Smart beta equity ETFs

As at May 31, 2012	Symbol	Management fee	Assets $mil
BMO S&P/TSX 60 Equal Weight Banks	ZEB	0.55%	$428
BMO Equal Weight REITs Index	ZRE	0.55%	$245
iShares Canadian Fundamental Index	CRQ	0.65%	$216
iShares U.S. Fundamental Index	CLU	0.65%	$170
Powershares FTSE RAFI U.S. Fundamental (CAD Hedged)	PXU	0.45%	$61

Engineered beta

Engineered beta occurs when you target specific diversification or volatility goals. Strategies that address specific exposures, attempt to alter volatilities or shape risk include leveraged, inverse, covered-call and low-risk or minimum-variance (see “Engineered beta equity ETFs”).

Engineered beta equity ETFs

As at May 31, 2012	Symbol	Management fee	Assets $mil
BMO Covered-Call Canadian Banks	ZWB	0.65%	$753
IPath S&P 500 VIX Mid Term Futures ETN	VXZ	0.17%	$530
Horizon Betapro NYMEX Crude Oil Bear Plus	HOD	1.15%	$211
BMO Low Volatility Canadian Equity	ZLB	0.35%	$11
Powershares S&P Low Volatility	ULV	0.35%	$6
First Asset Can 60 Covered Calls	LXF	0.65%	$5

No single indexing approach provides the answer to every market; combine them to address specific needs like broader diversification or risk control. Smart beta proponents have reasonable arguments, but controlling costs is one of the few things advisors can do to actively impact returns. This suggests lower-cost MCWas the way to go. However, investing style dictates the best approach, so find one in which you have confidence.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.