Why You Should Start Investing in Smart Beta ETFs in Canada

If you’ve never heard of Smart Beta ETFs in Canada, you are not alone. Although, you probably know about Exchange Traded Funds (ETFs), which have seen tremendous growth in Canada in recent years. According to the Bank of Montreal (BMO), as of the end of November 2021, total assets in ETFs amounted to $336 billion.

There is no shortage of regular ETFs. Your choice of online broker or robo-advisor can let you buy them. The growth in ETF assets in 2021 as of that date was $51.5 billion, or more than 15%. Furthermore, there are now more than 1,100 different ETFs available in Canada, offered by as many as 40 different providers. 

The top three ETF providers in Canada are RBC iShares, BMO, and Vanguard. Combined, they account for almost 70% of the ETF market! The three manage practically all of the top 10 to 15 ETFs in Canada, as ranked by assets. The largest funds are passively managed ETFs that make up the core of most investors’ portfolios. Even the smallest of these ETFs currently exceed $3.0 billion in assets. 

Given that the three largest providers dominate these traditional ETFs, competitors that entered the market later on came up with something new. They had to offer investors an alternative to the traditional ETFs that they already held. As a result, most of these providers came into the ETF market with one or more of the many variations of Smart Beta ETFs. 

Smart Beta ETFs: many shapes and sizes

Within the larger universe of ETFs, there is also a sub-category known as Smart Beta ETFs. The growth of this segment of the ETF market has been quite remarkable in itself. Smart Beta ETFs are a hybrid between traditional ETFs and actively managed mutual funds. Whereas traditional ETFs are usually constructed around market capitalization weighted indices, such as the S&P 500, smart beta ETFs are based on factors other than market cap. 

The term ‘smart beta’ suggests that rather than simply providing investors with the return of the market, i.e. beta, these funds are designed to generate higher returns than passively managed ETFs. Many of the new ETFs that have been introduced in Canada in recent years fall under the heading of Smart Beta. While most of these are equity funds, smart beta covers the entire range of asset classes including fixed income, commodities and cryptocurrencies. 

Equally-weighted ETFs

Aside from asset class, smart beta funds are characterized by their distinct strategies. Some of the more basic Smart Beta ETFs are those that are equally weighted. These are designed to address the problem that many traditional ETFs are now dominated by one or two large sectors. For example, even the S&P 500 has become heavily weighted in the technology sector. So the typical ETF that tracks that index would also be heavily weighted in a handful of large technology stocks.  

But now there are Smart Beta ETFs based on an equally weighted S&P 500 index. That is, the stocks in the index are weighted equally rather than being weighted based on their market capitalizations. So although technology might still be the largest component of the Smart Beta ETF, its weighting would not be as high as it is in the traditional ETF. An example of a smart-beta ETF in Canada is Invesco Canada’s S&P 500 Equal Weight Index ETF (EQL). This ETF has been available to Canadian investors since May 2018. 

Fundamentally weighted ETFs

The more elaborate Smart Beta ETFs that have sprung up in recent years are based on fundamental metrics. These ETFs can be based on factors such as valuation ratios, earnings growth, or a track record of consistently higher dividends. The rationale for these ETFs is that they are based on some criteria that gives more weight to stocks that, presumably, should perform better over time.

Again, because traditional ETFs are weighted by market capitalization, the largest stocks in those indices have likely already performed well and, therefore, usually trade at higher valuations.  An example of a Smart Beta ETF such as the ones described above is the iShares MSCI Multifactor Canada Index ETF (XFC).  This ETF invests in Canadian stocks based on four factors. Namely, value, momentum, quality and size. Its underlying benchmark is the MSCI Canada IMI Select Diversified Multiple-Factor Index. XFC is traded on the Toronto Stock Exchange in Canada and was launched in September 2015. 

A long-running dispute

There is no lack of controversy around Smart Beta ETFs. And this starts with the terminology used to describe them. Critics have argued that the name Smart Beta is simply a marketing term. It was designed to give investors the impression that Smart Beta ETFs are likely to provide investors with better long-term performance than conventional ETFs, or passively managed ETFs. In light of this, a more appropriate description for Smart Beta may be actively-managed ETFs’. 

Regardless of what they are called, more central to the discussion around Smart Beta is the question: do these ETFs offer investors a legitimate alternative to traditional ETFs? But given the sheer number of funds and the variations within the types of smart-beta ETFs that are available, the answer is not so straightforward. To that end, it is worthwhile taking a closer look at one class of actively managed ETFs that have caught on with investors and have seen significant growth in assets. 

Low-volatility ETFs

Another group of ETFs that has gained some notoriety are low-volatility ETFs. These are also actively managed ETFs as they are constructed by selecting the stocks in any particular market that have been less volatile over time. The result is that they may not capture as much of the upside in rising markets. However, by limiting the downside in declining markets, they should provide investors with some peace of mind.

As indicated, low-volatility ETFs have really made inroads since the first one was launched in 2011. As of April 2021, there were about 50 low-volatility ETFs in Canada with total assets at almost $10 billion. While all the major providers in Canada now offer a selection of low-volatility ETFs, the largest one is the BMO Low-Volatility Canadian Equity ETF (ZLB) with assets exceeding $2.9 billion as of December 2021.

Interestingly, the fund has only 47 different holdings and has a weighting in the technology sector of less than 3.5%. This differs quite substantially from BMO’s core S&P/TSX Capped Composite Index ETF (ZCN), which holds 246 stocks and has a weighting of almost 12.0% in the technology stocks. Regardless, if low-volatility ETFs do indeed provide investors with the downside protection that they are seeking, then perhaps there are valid reasons for including them as part of a larger portfolio.  

What’s the trade off with Smart Beta ETFs?

It’s clear that within the universe of Smart Beta ETFs, many have a certain appeal with investors. But investors should be aware of the drawbacks that come with the territory. For one, given that there is more work involved in managing these funds, there is an added cost as well.

To be sure, Smart Beta ETFs necessarily come at a higher price and this is usually seen through a higher management expense ratio (MER). This higher cost will certainly lead to some drag on performance. Investors need to determine if the supposed benefits are worth the higher fees. There are calculators that can help investors make informed fee decisions.

Another cost that usually comes with Smar Beta ETFs are the trading costs associated with maintaining the fund’s strategy. Since these ETFs need to be rebalanced more often, they typically require more trading than passively managed ETFs. It is difficult for investors to know how much trading is taking place behind the scenes because this is not disclosed by the fund managers. However, these costs also have an impact on performance. 

A look at what may lie ahead

It’s clear that the traditional ETFs will continue to dominate the Canadian market. However, investor appetite for more exotic products that cover some of the obscure categories should lead to a steady stream of new ETFs. Just to illustrate the point: in December, a new US ETF under the symbol BAD was listed on the New York Stock Exchange. The symbol was not chosen randomly. The ETF is designed to replicate the performance of an index made up of betting, alcohol and cannabis companies. Investors waiting for a Canadian equivalent can only hold their breath in anticipation.