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Exchange-traded funds (ETFs) have been grabbing an ever-growing market share of the investment fund market from mutual funds. And with the March market meltdown, ETFs have also been grabbing their share of business news headlines – especially the highly leveraged variety where liquidity can become an issue during market panics. ETFs have in fact become such big business that many fund sponsors are now offering the same fund in both ETF and mutual fund versions in order to stay competitive. So I thought it might be useful to revisit the ETF market and look at some of the different types of ETFs now available. As you’ll see, we’ve come a long way from the passive, plain-vanilla, stock-market-index-tracking fund.
Passive ETFs
These are what comes to mind for most of us when we think about ETFs. They are designed to provide broad, low-cost exposure to the main market indices. Quite simply, most of these ETFs track an index that has been constructed using market capitalization as the main driver for security weightings in the portfolio. Typically, the larger the company, the bigger the part it plays in the index.
Some may fault this methodology, arguing that market capitalization is not an indicator of quality and that using it as a weighting scheme could result in the most overvalued stocks having a bigger weight in the index than fundamentals may warrant.
For example, the S&P/TSX Composite Index, the S&P 500 Composite Index, and the MSCI EAFE Index are market-cap indices that have been used as the foundation for many ETFs. In addition to these main indices, there are several other passive options, including indices from FTSE/Russell, Solactive, and others.
Passive ETFs have several advantages, including low cost, full transparency, and more favourable tax treatment. They are really a great building block for many portfolios.
As has been shown many times over, the majority of active managers struggle to outperform their benchmarks, and passive ETFs provide a cost-effective way to access the very benchmarks many of the active managers are trying to beat.
Obviously, the biggest drawback to investing only in passive strategies is that you will never be able to outperform the benchmark, because your return will be simply the return of the index less the costs (and some friction for trading costs, tracking error, and premiums/discounts). Holders of passive, broad stock-market ETFs have experienced this drawback first-hand over the past several weeks. For example, the BMO Junior Oil Index ETF (TSX: ZJO), which passively tracks the Dow Jones North American Select Junior Oil Index was down 68.1% year to date as of March 31.
Smart beta ETFs
“Smart beta” is really a catch-all term that is used to describe ETF portfolios that are built using a weighting strategy that is not based on market capitalization. Such strategies tend to be rules-based, systematic, and quantitative in nature. They can range from the very simple to the very complex.
A simple smart beta strategy would be the equal-weight strategy, in which the ETF invests in an equal weighting of each of the companies that make up an index. A more complex smart beta strategy may involve scoring a universe of stocks on several fundamental factors, including book value, cash flow, sales, and dividends. Each stock is scored, and the best-rated stocks make up a larger piece of the index than those companies with less favourable scores.
Within the smart beta space, there are a few different types, including these more popular strategies:
* Fundamental. These ETFs score a universe of stocks on a variety of fundamental criteria. One of the better-known companies involved in the fundamental space is Research Associates, a Newport Beach, California investment management firm founded by Rob Arnott.
The premise of fundamental indexing is that companies are scored on fundamental factors that have historically been found to lead to outperformance. This methodology also eliminates the criticism of cap-weighted indexing where the most overvalued companies constitute the largest portion of the index.
The theory is very sound, but the performance results to date are mixed. Typically, fundamental ETFs are more expensive than cap-weighted ETFs.
* Factors. This has evolved into one of the most popular forms of smart beta strategies of late. There have been many new entrants into the factor space, including mutual fund giant Fidelity. Other very active entrants include Vanguard, Invesco, and iShares.
The premise of factor-based strategy is based on academic research that has shown various factors, or common traits, in securities that have gone on to outperform. There are new factors being identified, but the main ones include volatility, momentum, quality, value, dividend yield, and size.
Volatility – Historically, we have been taught that if you want to earn higher returns, you need to invest in riskier investments. There is some truth to this in that over the long term, equities tend to outperform bonds, which tend to outperform cash. However, within the equity sleeve, an anomaly has been identified that shows that funds that have lower levels of volatility have actually outperformed those that have higher levels. To capitalize on this, these factor ETFs will score each company based on its risk level and then weight the company accordingly in the portfolio.
Momentum – These strategies look to capitalize on market trends by investing in stocks that have shown positive price movement over a certain period.
Quality – This is most like what a traditional fundamental manager does. The quality factor scores stocks on several metrics, including profitability, earnings quality, financial leverage, asset growth, and corporate governance. Historically, those companies that score well on quality metrics are likely to outperform those that score lower.
Value – This is the simple concept of investing in stocks that are inexpensive. Screens are run to find companies that are trading at valuation levels well below the index or the peer group. It is believed that over the long term, stocks with lower valuation will outperform those trading at higher multiples.
Dividend Yield – Dividends have been shown to be a significant contributor to the total return of a stock over time. Some studies have shown that reinvested dividends can make up more than half to two thirds of the total return over time. Dividend funds rank stocks based on the dividend yield, with those with a high, sustainable dividend yield making up a larger portion of the index than those with lower yields.
Size – Small cap stocks have been shown over the long-term to outperform their large-cap brethren. These strategies focus on small- and mid-sized companies.
Active ETFs
These are about as close to a traditional mutual fund as you can get. With active ETFs, there is a portfolio manager who is making active buy-and-sell decisions in the portfolio. In terms of numbers, there are not nearly as many active ETFs available in Canada as there are in the U.S. There are a couple of reasons for this.
The first is that many portfolio managers are hesitant to show their full portfolio and potential buy lists to market makers in real time, which limits the number of entrants. Another reason is that these ETFs tend to carry much higher costs than the passive ETFs.
Most of the growth in active strategies has come from mutual fund companies that are taking existing mutual fund mandates and offering them as ETFs. Some of the bigger players in the active space include Horizons and Mackenzie. While I’m typically a fan of ETFs, I’m not certain we’ll see the active versions catch on the same way that other ETF strategies have. However, we could also eventually reach a point where it will become the norm to see investments offered across various structures, including mutual funds, pooled funds, and ETFs. Time will tell.
Dave Paterson, CFA, is a money manager and an expert on investment fund research and due diligence on a variety of investment products.
Notes and Disclaimer
© 2020 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.
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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