Is smart beta the fourth line of investing?

Scotty Bowman, widely considered the best NHL coach of all time, used specialty players like Doug Jarvis, Jimmy Roberts and Bob Gainey to tremendous advantage during the Montreal Canadiens’ dynasty years in the 1970s and 1980s. Since then, and until relatively recently, specialty fourth lines have been used to thwart specific opposition lineups.

In the investing world, some advisors think they need alternative approaches to outperform passive investing. Are smart beta strategies the fourth line of investing? Smart or alternative beta describes active strategies used to correct the biases of capitalization-weighted indices towards growth, momentum, and popularity leading to overvaluation, as identified by Rob Arnott, founder and chairman of Research Affiliates.

These higher-cost strategies are promoted as alternatives to passive low-cost ones (see the management fees in “Table 1”).

But should advisors use them to replace core holdings? Smart beta strategies are either factor-based or diversification-based, say Qian, Alonso and Barnes in “The Triumph of Mediocrity: A Case Study of Naïve Beta” (The Journal of Portfolio Management, Summer 2015). Factors, including value, growth, quality, size and momentum, require investors to assume that one, or a combination, will lead to outperformance. For example, an investor could concentrate on large caps or higher-quality holdings in a market subject to liquidity problems, like the current U.S. high-yield market.

Meanwhile, diversification-based strategies do not require prior market assumptions, and are typically subdivided into four strategies: equal weight, minimum variance, maximum diversification and risk parity. The authors find neither approach is necessarily smart, but concede they could be considered beta and might even outperform. In Canada, all these strategies tend to be grouped together. This article will use these two groupings and focus on low-volatility strategies.

Factor-based

Factor-based strategies were probably smarter in the 1960s, say the authors, when value, size and momentum were used to explain deficiencies in the single-factor capital asset pricing model (CAPM). In fact, the paper suggests that current iterations are less effective than earlier models.

If advisors have strong views about factors that will succeed during a particular investing period, these alternative strategy ETFs may be useful.

Each factor has outperformed in different markets, but predicting when they will do so is not easy. Some factor-based investors look through the lens of a perpetual investing time horizon that isn’t appropriate for many aging clients.

Diversification-based

These strategies do not require a market view. Their discipline is applied in an equal and diversified way, leading the authors to label them as naïve. But each beats the benchmark. The paper focuses on:

• equal weight (assumes all holdings are equal);
• minimum variance (assumes all portfolios, regardless of asset allocation, have the same expected return);
• maximum diversification (assumes all portfolios, regardless of asset allocation, have the same Sharpe ratio); and
• risk parity (assumes equality of risk contribution for each asset class).

In Canada, there are several industry-centric equal-weight ETFs, but only Horizons S&P/TSX 60 Equal Weight (HEW) is available for broad equities (disclosure: the author’s firm advises Horizons).

Four minimum variance portfolios are available (see Table 2, this page). The portfolio with the lowest risk among those with the same expected return is the minimum variance portfolio.

Since maximum diversification assumes all investments have the same Sharpe ratio, their expected returns vary directly with their volatilities. Maximizing the Sharpe ratio produces the target portfolio. And budgeting risk for the entire portfolio among the available asset classes based on the volatility of each results in the risk parity portfolio. But since neither of these last two strategies is available in a Canadian ETF, we’ll focus on minimum variance or low- volatility strategies.

The volatilities (standard deviations) from August 2013 to December 15, 2015 for ZLB, TLV and XMV showed all ETFs had lower risk compared to the S&P TSX Composite Index, represented as XIC (see tablet edition). ZLB and TLV maintained similar low volatility until recently, but annualized returns were different.

For the three years ending November 30, 2015, ZLB returned +17.4%, TLV +11.4% and XMV, +9.8%. XIC returned +6.2%. One reason is that BMO caps ZLB’s sector weights and has a more diversified portfolio. Typically, low-vol strategies are prone to concentration by sector. The lesson for advisors is to understand the differences.

Bringing it back to hockey

Today, most fourth lines in the NHL include “skill” players. Even the Leafs use fourth liners Byron Froese and Brad Boyes on power plays. Bowman also recognized this in his use of multi-purpose stars Pavel Datsyuk and Henrik Zetterberg. The speed of today’s game means most match-ups must have offense built into them.

Similarly, factor-based strategies are gradually giving way to diversification strategies among sophisticated institutions like CPPIB, OTPB and AIMCo. Trying to beat a passive index is a laudable pursuit, but it bears repeating that most active managers can’t do it consistently.

TABLE 1: Canadian smart beta ETFs––Factor-based

TABLE 2: Canadian smart beta ETFs––Diversification-based

Mark Yamada

Investments

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