There is an evolution underway in the exchange-traded funds (ETFs) space that allows financial advisors to construct better portfolios for their clients.

ETFs originally were designed to replicate the returns of well-known, market capitalization-weighted indices such as the S&P 500 composite index. Today, the index methodologies that underlie certain ETF portfolios have advanced in three significant ways to create the potential for superior risk-adjusted returns or even market-beating performance.

First, indices have been developed to gain exposure to a broader range of factors, including drivers of return and risk that originate from a specific dimension of the stock market. Advisors are well acquainted with the value/growth and large/small factors upon which ETF portfolios have been designed for many years. Now, new ETFs have been designed to replicate indices designed around volatility or momentum factors.

Low-volatility ETFs hold stocks that have recently displayed lower volatility than the overall market. Historically, low-volatility stocks have tended to outperform the market on a risk-adjusted basis.

The causes posited are behavioural and include both the tendency for investors to pursue the “lottery ticket” effect of high-beta stocks and the inability of institutional investors to tolerate the high tracking error of these strategies. Both BlackRock Asset Management Canada Ltd.‘s iShares division and Invesco Canada Ltd.‘s PowerShares division have launched low-volatility ETFs focused on different geographical markets.

Momentum ETFs gain exposure to stocks that recently have shown positive price momentum. Momentum is a well-documented anomaly in finance, with numerous studies confirming that past investment winners – when measured over periods of approximately three to 12 months – tend to keep on outperforming while past losers tend to keep underperforming. Cognitive biases such as anchoring and confirmation bias, as well as the bandwagon effect, are possible explanations.

A second advancement is the development of ETFs that replicate indices that combine two or more of factors, with the objective of improving performance over a single-factor index. Several studies have found that introducing certain momentum parameters into a value-based strategy can improve performance, and vice versa. First Asset Investment Management Inc. has introduced three ETFs that replicate Morningstar Inc. indices that take a multi-factor approach.

Finally, other ETFs are replicating indices that combine qualitative ratings with quantitative parameters in an effort to further enhance risk-adjusted returns. Morningstar has developed an “economic moat” rating for stocks, based on an assessment of each company’s sustainable competitive advantage.

Morningstar has combined this rating with both its “distance to default” measure, which is a rating of the likelihood of financial distress, and its dividend yield-ranking system to create the Morningstar dividend yield focus index. The result is an index that combines value, financial quality and low-volatility elements. IE

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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