They not necessarily the lowest-cost approach. They are not the portfolio that will necessarily beat the traditional index all the time. They are not always going to be sleep-at-night portfolios. They will tend to be the smartest investment approach at a reasonable price. Several of the ETF providers have thought pieces on the topic. They’re known in the industry as smart beta, though many do not like that name.

Think of beta as the return of the traditional market-cap weighted index like the S&P 500 or the S&P TSX. Smart beta indices (ETFs) are based on relatively transparent quantitative approaches that seek to provide better risk-adjusted returns than the traditional index. They represent a move away from the traditional market-cap weighted indices toward alternative weightings purporting to offer either better diversification or greater efficiency than the standard market cap-weighted approach.

Historical back-tests of these indices often show better risk-adjusted returns than the traditional market-cap indices, but not always, because they tend to be much smaller selections from a broader universe. You have to do your homework because no two are alike. This is your first assignment!

There is quite a debate on whether smart beta indices should be considered an active or passive form of investing. In my mind, a passive form of index investing comes from a rules-based approach to creating your index. An active approach is not from a rules based approach and incorporates manager opinion about the future performance of a company. Most forms of smart beta investing are rules based and therefore fall in the passive approach to indexing. This is my view on the subject, but opinions are wide ranging.

Vanguard believes that “passive management can be used to replicate smart beta indices but the indices themselves are a form of active investing in that subjective assumptions and choices are required as to where the emphasis is to be placed: they establish the rules to decide on how to deviate systematically from the market-cap portfolio, how frequently and by how much. Only the cap-weighted portfolio can be considered as a genuinely passive strategy – it is the only buy-and-hold portfolio that theoretically could be held in equilibrium by every investor.”

What are the different factors?

Factors can be thought of as characteristics of stocks that are important to explain their risk and performance. The traditional index approach groups stocks by their size (capitalization) and that index is known as beta or the market return.

A large number of academic papers published since this approach became popular in the 1960s found that returns and risks of stocks can come from many factors:

• Value characteristics that a Warren Buffet would look at like the price-to-book or the price-to-earnings of a company measure how cheap a stock is relative to others. It has been found that on average, over time, cheaper stocks tend to out-perform other stocks, in particular expensive stocks.
• Volatility is a risk measure indicating by how much the price of a stock fluctuates. Evidence that less volatile stocks, with less price fluctuations, generate at least comparable returns to riskier stocks renders low volatility stocks much more attractive for investors: same returns in the medium to long-term with less uncertainty.
• Quality or profitability tends to generate higher returns than other stocks, in particular when compared to the least profitable companies. Different measures of profitable can be used, e.g. return-on-equity.
• Momentum stocks with the strongest price trends, e.g. stocks with the strongest out-performance relative to other stocks as measured over the previous 12 months also tend to continue to outperform.
• Size of smaller companies tend to generate higher returns than larger stocks over the medium to long-term. Typically, due to the law of large numbers. Investors will pay more for companies during their higher growth phase compared to larger mature companies.

Over the next few months, I hope to have most of the ETF issuers in Canada on the show to discuss the unique features of their smarter ETF indexing methodologies.

Learn 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 $175,000 for charity thanks to BNN viewers and our sponsors.