One of the most significant innovations in ETFs has been the development of “smart beta” products. These ETFs use alternative index construction rules in a transparent fashion to obtain exposure to dimensions of the market or factors that have earned long-term return premiums.

This strategy is different from the conventional, broad market index capitalization-weighted methodology that traditional ETFs employ.

MSCI Inc. identifies six smart beta factors: high dividend yield, small size, low volatility, momentum, quality and value. Other index providers offer similar factor-based indices. Clients can access a broad range of ETFs that have the objective of replicating these indices, net of costs.

By definition, indices must be investible and replicable. Hence, index rules typically are designed to ensure sufficient liquidity by encompassing wide-ranging exposure to a particular dimension of the market.

For example, as of Oct. 31, the MSCI U.S. value index contained 317 stocks with an aggregate market cap of US$9.64 trillion, while the corresponding MSCI U.S. growth index contained 369 stocks with a market cap of US$9.6 trillion. MSCI’s value and growth methodology, similar to that of many index providers, essentially splits a particular market into value and growth classifications, each targeting approximately 50% of the market in question.

This approach, although conducive to the design of ETFs that require underlying liquidity (defined as the ability to absorb large quantities of capital over a short period of time without excessive price impact), does not capitalize on the return potential of factor-based concentration. Academic research has identified that index rules concentrating on narrower segments of a market dimension earn higher long-term returns.

A recent study – Diversified or Concentrated Factor Tilts, published in the Journal of Portfolio Management – compared the performance of the broad U.S. market from 1975 to 2014 to two multi-factor portfolios. One multi-factor portfolio was diversified and was composed of the top 50% of stocks (as ranked by factor score), while the second multi-factor portfolio was concentrated in the top 20% of stocks (as ranked by factor score). Although the 13.9% annual return of the diversified multi-factor portfolio outpaced the broad market’s 12.3% return, the diversified portfolio lagged the 15% return earned by the concentrated portfolio.

Using data for the period of 1927 to 2015 that was compiled by Ken French, finance professor at the Tuck School of Business at Dartmouth College in New Hampshire, an equal-weighted portfolio concentrated in the top performance decile of value stocks (as measured by book value to market value) had an average annual return of 19.5%, far outpacing the 16.2% return of the more diversified top five deciles and the 10% return of large-cap stocks in general. Similarly, an equal-weighted portfolio concentrated in the bottom decile of small-cap stocks had an average annual return of 17.5%, far ahead of the 13.1% return of the more diversified bottom five deciles of stocks (as measured by market cap).

Concentrated-factor portfolios don’t provide this premium for free. They typically have higher volatility and tracking error than more diversified factor portfolios and can underperform for lengthy periods. Hence, they are best combined with broad market-based ETFs. IE

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm.

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