One of the best presentations last week from ETF.com’s Inside ETFs conference was from Michael LaBella, a portfolio manager at QS Investors. The presentation made the case for why smart (factor) index portfolios should be used by all investors.

The adoption of passively managed index funds (including ETFs) has been on the rise for a decade compared to actively managed (security selection) funds. The research surrounding security selection portfolios shows that the vast majority of active managers do not beat the markets after fees. The research suggesting asset allocation is the key to managing portfolio risks and returns are quite positive. Hence, the shift to low cost market exposure is growing rapidly. However, the traditional market cap weighted indexes have some challenges and the fastest growing segment of the ETF world are smart (factor) indexing.

There are two main considerations with market cap weighted indexes. Both are centered around concentration issues. As diversified as the S&P 500 is in terms of geographic income and sector exposure, the top 10 holdings are as large as the bottom 296 and equal 18.2 per cent of the index. You have to ask the question, is owning the largest stocks appropriate for all investors? Increasingly, the answer is less clear. Make no mistake, the S&P 500 is the most important index in the world at about 35 per cent of the world capitalization.

Internationally, three sectors make up half the US index. In Canada, two sectors Financials (35 per cent) and Energy (20 per cent) make up more than half the index. In international developed markets, three countries Japan, U.K, and France, make up more than 50 per cent of the index. Increasingly, this concentration is making it more difficult to get the portfolio diversification investors need while volatility risks are rising.
One solution to this concentration problem is to equally weight and index versus market capitalization. This tilt is the size factor. Smaller cap stocks tend to grow fast than larger cap stocks in the long run. The S&P 500 Equal Weight outperformed over 60 per cent of the time over the last 25 years and outperformed nearly 75 per cent of the time over the last 15 years.

Enter the style strategies of smart factor investing. Last week we showed how low the correlations are between the factors and how that can help reduce risk in portfolios. This week we can see that these smarter indexes can and have generated significantly better long-term returns than the traditional capitalization weighted indexes. Higher average returns and lower risk should be everyone’s goal when building portfolios. Whether you are a do-it-yourself investor or a financial advisor, utilizing this growing style of index (ETF) investing should help portfolios do better in the long run at a significantly lower cost than the traditional security selection mutual funds.

One caution, the benefits of diversification still apply. You may have heard that diversification is your only free lunch when it comes to investing—never forget this principle. Simply recognizing that the momentum factor tends to do the best in the long run is not enough. In choppy and volatile markets momentum tends to underperform significantly given the nature of how this style of investing works.

Watch this article in a video segment online at BNN.ca

I love the idea of using smart indexing strategies to add returns and lower volatility in portfolios. Learn how to use techniques like this and how to be a smarter investor in our 7th season across Canada speaking tour. Free registration at www.investorsguidetothriving.com. Help us raise money to fight Cancer and Alzheimer’s by making a voluntary donation with your registration. Over the past few years, Berman’s Call roadshows have raised over $200,000 for charity thanks to BNN viewers and our sponsors.