The Biggest Growth Area for ETFs is in Active/Strategic Strategies

After Day 1 of the Inside ETFs 2018 conference, I have a few takeaways for BNN viewers. Bitcoin ETFs exist in Sweden (not coming to the US anytime soon), Blockchain ETFs are out (BLOK – Amplify Transformational Data Sharing ETF), we are expecting one in Canada too, and the biggest growth area in the coming years are active/strategic strategies.

Recall last year we highlighted Smart Beta Indexing ETFs. These are alternative ways to create market indexes that are not just based on the size of the companies. Market cap indexes tend to be top heavy and are less diversified than you think. Just have a look at the influence of the top 5 companies in the S&P 500 index. The top 5 stocks are 12.7% of the index, which is the same weight as the bottom 245 companies. The top 50 companies control 50% of the index. Increasingly, it’s getting more difficult for stock pickers to beat the market cap index returns. Concentrated portfolios are often seen as higher risk by the regulators. And while no one would say owning the entire S&P 500 does not offer broad diversification, we have seen these problems before. Think Nortel back in 2000 at about one-third the weight of the S&P TSX and how badly that ended.

They are smarter ways to select securities than simply putting even more money into the largest companies. Just think about what a prudent portfolio manager actually (or ought to) does today. They filter for companies with the strongest financial data typically at a reasonable price. Computers can do this today, automatically in real time for a fraction of the cost of higher price mutual funds. These active/strategic funds are likely to continue to grow. The ETF is simply the most elegant way to deliver the investment vehicle to the end client.

Multi-factor models may be among the most interesting. Taking a bottom up approach to selecting the best stocks that share the same common features. There are two main kinds of risks when investing. Systematic or market risk and idiosyncratic or the risk of owning individual companies. We can control idiosyncratic risk via diversification across sectors and industry groups and we can control systematic risk via asset allocation. i.e. holding different types of assets in your portfolio (stocks, bonds, real estate, cash, currencies, commodities).

In a multi-factor ETF, the strategic security selection is primarily focused on reducing idiosyncratic risks. The SPHD (PowerShares High Dividend, Low Volatility) ETF selects the top 75 dividend payers in the S&P 500 index and then selects the 50 lowest volatility stocks of that group. The risk factor (beta) or sensitivity to the market risk is around 60% of the S&P 500 with about the same performance over the long run.

The ETF (SPHD) costs 30 bps vs. 9.5 bps (SPY), so it’s a bit more expensive, but it generates about double the yield of the S&P 500 with significantly less risk. In a bear market, it’s still going to fall, but in all likelihood, it falls about 60% of the downside of the market (SPY).

We can expect to see more of these smarter indexing choices in the coming years as active/strategic styles of investing that used to cost 2.5% in a full fee mutual fund are now available at a relatively low cost. These are the exact types of holdings I want to have in my (sleep-at-night) portfolios when I’m concerned about overall market risk. They won’t get rid of the market risk, but they will help make the ride much smoother.

As for controlling systematic risk, that is where asset allocation can help. There is no better way to control your overall outcome than by having assets in your portfolio that provide a stream of returns that are lower correlated. This will be the major focus of my current BNN roadshow. Recall, last year we introduced the idea of investor behaviour types. This time around we will drill down into how to build and manage ETF portfolios to suit your investor personality with great ETFs like SPHD and others. Please visit The Investor’s Guide to Thriving to register for the 2018 show in your city.

Watch Larry discuss this topic in a video segment on

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