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The March market meltdown demonstrated the major downside of passive, index-tracking exchange-traded funds – that is, they’ll follow their index wherever it may lead. I recently looked at some of the bigger passive ETFs as a way to test the market waters after values were beaten down in March. But there are a couple of other ETF strategies that have become popular in recent years, some of which might also serve as a more focused, and in some cases a volatility-minimizing, way to start getting back into equity markets. One such strategy is the so-called smart-beta ETF.
While passive ETFs typically use market capitalization to determine the weights of securities in the portfolio, smart beta strategies use an alternative weighting scheme that could be based on many different things, such as fundamental strength, dividend yield, or other style factors. They’re not fully “active” in the sense of giving a manager full discretion in the mandate, owing to the constraints of the smart beta formula being applied. But in that sense, they’re more “active” than the standard index-tracking ETFs.
Here are some of my top picks in the smart beta space.
Invesco Canadian Dividend ETF (TSX: PDC) – Dividends have made up a substantial portion of the total return of equities over the long-term, and there is little sign that this will change into the future. That makes dividend investing a solid strategy for most investors.
This offering from Invesco is one of my favourites in the Canadian dividend category. It invests in liquid, high-yielding Canadian equities that have a track record of growing dividends. To be included in the index, a company must have paid stable or growing dividends in each of the past five years. There are no limits on sector exposure, so it can get pretty concentrated from a sector perspective. Unlike some of the other dividend mandates, this focuses more on larger companies. It has historically offered a nice balance of return and lower volatility. It won a FundGrade A+® Award for 2014.
iShares MSCI Minimum Volatility USA ETF (TSX: XMU) – This iShares ETF tracks an index that is designed to provide exposure to a portfolio of lower volatility stocks. The methodology uses more of an optimization approach to build the portfolio. While the focus is on low volatility, the sector mix is roughly in line with the broader market.
The index providers then use an optimization process to build the mix of securities that provides the best risk-return tradeoff. It tends to be a touch volatile, but the returns have also been slightly higher. I have found that this methodology has produced slightly better results in the U.S. and international markets, making this my top pick. A multi-year FundGrade A+ Award winner.
BMO U.S. Dividend ETF (TSX: ZDY) – ZDY invests in a portfolio of U.S. dividend-paying stocks. The portfolio is constructed using a rules-based approach that considers a stock’s liquidity, three-year dividend growth rate, dividend yield, and dividend payout ratio. These factors are scored, and the top 100 or so most attractive stocks make up the fund’s portfolio. It’s been a very solid pick in the U.S. dividend category.
Absolute returns have trailed the broader U.S. market slightly, but with the lower volatility, risk-adjusted returns have been comparable. This version is unhedged, while hedged version (ZUD) offers the same underlying investment exposure with all of the foreign currency exposure hedged back to Canadian dollars. I prefer the unhedged version as it tends to be less volatile, particularly in a market selloff. A multi-year FundGrade A+ Award winner.
iShares MSCI EAFE Minimum Volatility ETF (TSX: XMI) – This ETF is built using a very similar approach to XMU, discussed above, with a key difference being that it uses the MSCI EAFE Index as its benchmark. It roughly matches the country mix and sector exposure of the broader index and is optimized to produce the best risk-reward balance. Returns over the past five years have outpaced the broader market with lower volatility. More recently, it has outperformed the category average. A multi-year FundGrade A+® Award winner.
This is one of the few international equity offerings that doesn’t include U.S. equities. I am more likely to blend this with a U.S. equity option when building my own portfolio, rather than using an option that incorporates both U.S. and international stocks. Costs are reasonable, coming in with a management fee of 35 basis points, compared with 20 bps for the broader EAFE Index.
BMO International Dividend CAD-Hedged (TSX: ZDH) – Like ZDY discussed above, this ETF provides exposure to a diversified portfolio of high-yielding equities, with the key difference being that this one is focused on non-U.S. equities.
The investment process is identical, using a rules-based approach that considers a stock’s liquidity, three-year dividend growth rate, dividend yield, and dividend payout ratio. These factors are scored, and the top 100 or so most attractive stocks make up the portfolio. This version is fully hedged to Canadian dollars, while its companion ZDI is unhedged.
Unlike the U.S. version, the fully hedged fund has resulted in a more favourable risk-reward profile. More than 70% of the portfolio is invested in Europe, and with the uncertainty caused by Brexit and the overall economic environment in the region, I am not bullish on the outlook for the euro. That leads me to favour this fully-hedged version.
As always, discuss these strategies with your advisor before investing, keeping in mind that stock markets are still very volatile. And remember, too, that in the case of volatility-minimizing strategies, “low” volatility does not mean “no” volatility.
Dave Paterson, CFA, is a money manager and an expert on investment fund research and due diligence on a variety of investment products
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Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently, and past performance may not be repeated. No guarantee of performance is made or implied. This article is for information purposes only and is not intended as personalized investment advice. Dave Paterson is employed as an advising representative (portfolio manager) by Empire Life Investments Inc. (ELII), a subsidiary of Empire Life Insurance Company. ELII is the investment fund manager and portfolio manager of the Empire Life Mutual Funds and the portfolio manager of the Empire Life Segregated Funds (collectively, the Empire Funds). As such, his employment and his compensation may be connected to the success of ELII and the Empire Funds. From time to time, the Empire Funds may buy, sell, hold, or otherwise have an interest in securities that may be discussed in this report.
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