For years now, financial advisors have been offered the choice between using index-based exchange-traded funds (ETFs) or actively managed funds to construct their clients’ portfolios. Simultaneously, a seemingly never-ending debate has raged over the merits of passive index vs active investing.
Today, however, innovations in portfolio design are creating an investment continuum of complexity that erases this binary choice. The continuum begins with funds based on market capitalization-weighted indices such as the S&P 500 composite index and moves to classic size (e.g., large-, mid-, small-cap) or style-based (e.g., value, core, growth) indices or combinations thereof. The continuum then progresses to new, factor-based indices as well as inventive, rules-based strategies, followed finally by a gamut of active money-management approaches.
MSCI Inc. has created an entire suite of indices based on market factors that enhance this continuum. A factor is a common characteristic of a group of securities that explains their unique risk and return parameters. As these factors have earned long-term premiums to the broad market, which are viewed as arising from systemic risk sources, their excess returns are typically called “risk premia.”
MSCI has identified six equities-related risk premia factors – high dividend yield, low size, low volatility, momentum, quality and value – and created a family of factor indices to access their performance. MSCI rightly argues that indexation provides a transparent avenue to pursue the excess returns of exposure to these factors without the incremental cost and style drift of active management.
The historical performance of these factor indices is attractive. For the 15 years ended Dec. 31, 2013, returns on all these indices bested the S&P 500. However, the factor indices have significant differences in risk characteristics. The low volatility and quality indices achieved higher returns with lower standard deviation and drawdowns than the S&P 500. Conversely, the size, value and momentum indices achieved higher returns with greater volatility and drawdowns.
Not surprising, many of these factor indices are being replicated in ETFs. BlackRock Investments LLC has introduced iShares MSCI USA Quality Factor ETF, adding to the firm’s previous introductions of momentum and low-volatility ETFs. Van Eck Securities Corp., which distributes Market Vector ETFs, has launched international and emerging-market ETFs that seek to replicate the MSCI high dividend yield and quality indices for these regions. Expect to see more ETFs like this in Canada.
Advisors are warned that long-term studies of these risk premia factors have found that any individual factor can underperform for years. Hence, diversification among factors and patience remain critical.
In Canada, Purpose Investments Inc. has launched a suite of low-cost ETFs and funds as share classes within a mutual fund corporation, combining tax advantages with an array of advanced investment strategies. Several of Purpose’s funds use cutting-edge rules in their portfolio construction. These manage risk in a transparent and comprehensible fashion and thus combine some of the best features of passive and active management.
Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own the securities mentioned herein.
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