Traditional indices, known as capitalization-weighted (cap-weighted)
indices are derived by aggregating companies of a region or variety and
giving them a weight in the index based upon their market capitalization
share of the aggregate holdings. While simple, this construction
methodology has proven somewhat inefficient given the concentration
accorded to larger, growth-oriented companies which then holds hostage the
index performance to these companies’ performance.
Smarter beta – the best of both worlds
What if there was a way to take advantage of some of the desired qualities
of cap-weighted index investing while eliminating some of its known
weaknesses? It appears that institutional investors have already embraced
this utopic notion and have expanded upon research that really became
popular in the 1990s, which indicated that identified certain fundamental
characteristics that have exhibited excess returns above the market.
Consensus among experts2 seems to be that apart from the market
exposure to capture the long-term equity market risk premium, six
systematic factors are worthy of investor attention. These commonly
accepted factors are:
* Low risk:
Low volatility securities outperform highly volatile securities
Small securities outperform large securities
Securities that are cheap compared with their fundamental value outperform
Securities with strong price appreciation over the previous period tend to
(commonly defined by profitability and investment): Enterprises with strong
and growing profitability outperform those that are weakening.
Develop your core portfolio by factors diversification
We have seen it before. You implement a strategy at just the opportune
time. It does well for a while. Then it starts not to “do well.” Like many
active strategies, factor research2 has been pretty conclusive. While the
systematic factors above add value over long periods, in the shorter term,
specific systematic factors may exhibit variability, including periods of
underperformance relative to the cap-weighted index.
Believe it or not, this may actually be a good thing.
The fact that some systematic factors demonstrate higher returns and higher
volatility than the cap-weighted index while others have higher returns and
lower volatility than the cap-weighted index opens the door to
diversification of investment portfolios by systematic factors.
Investors have begun to take advantage of the fact that while some of the
factors do well in a particular economic regime or market cycle and others
do not, diversifying among factors (i.e., investing in a multifactor
strategy) can actually lead to a smoother risk-return profile than the
underlying cap-weighted index.
By implementing a multifactor portfolio, then, one could expect the
* Lower volatility portfolio with higher Sharpe ratios (returns adjusted
* Higher information ratios (active returns adjusted for risk).
* Lower tracking errors (variability of return relative to the cap-weighted
* Less dependency on a particular regime over the business cycle.
As institutional investors have been doing for over a decade, individual
investors now have a way to capture the best of both worlds. Cheap,
transparent, and rules-based investing that can be tilted, managed, and
constructed to produce better returns per level of risk. As always, talk to
your advisor before implementing this approach to investing.
1. According to Morningstar, in 2017 a total $692 billion flowed into
passive funds, while almost $7 billion flowed out of actively managed funds
in the U.S.
2. Source: scientificbeta.com
is an ETF specialist at Desjardins Global Asset Management. He is
responsible for solutions that are tailored to the needs of Desjardins’
clients and partners. This article first appeared in the Spring 2018
Your Guide to ETF Investing, published by Brights Roberts Inc. Reprinted with permission.
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