ETF Launches, Smart Beta Indices, and Low Volatility Indexing

new etfsMartin Raab:  Stephen M. Hammers, CIMA / Co-Founder, Chief Investment Officer at Compass Efficient Model Portfolios LLC, talks about his latest ETF launches, smart beta indices, low volatility indexing versus volatility weighting and the plans ahead.

Steve, first of all: Could you briefly describe your company?

Sure. Compass EMP Funds manages approximately $1.6 billion in assets across 16 index based mutual funds and 3 Exchange Traded Funds. The Compass EMP Funds are offered on over 150 brokerage firms.

Additionally to your existing family of mutual funds, you recently launched three ETFs claiming they will track proprietary Smart Beta indexes. Smart Beta is meanwhile an often used buzzword. Why are these three underlying indices smart?

Smart Beta Indexes are only effective if the index provides additional value in terms of risk or return compared to traditional cap weight indexes that are assumed to have a market beta of one.  The CEMP Volatility Weighted Indexes [Ticker CFO, CFA and CDC] are designed to provide are more efficient stock market. When you require all stocks to have four quarters of profitability and weight the stocks, or the profitable market, based on each stock’s volatility, you have a better representation of the true risk and return of the market. The results over time are staggering. Since September of 2000, the CEMP US Large Cap 500 Volatility Weighted Index beat the S&P 500 Index 268.66% to 78.20% with an annualized alpha of 6.02% and a beta of 0.86.

How exactly works the investment strategy?

All of the CEMP Volatility Weighted Indexes are based on the same premise, which is 500 of the largest stocks with four quarters of profitability. The stocks are then weighted based on their daily standard deviation. This means that low volatility and high volatility stocks are included, but they are weighted to equalize the volatility on all stocks. In other words the stocks with higher volatility have a lower weighting and stocks with a lower volatility have a lower weighting.

Which investors do you primarily target with your recently launched ETFs?

We target all investors that have been utilizing cap weighting and fundamental weighting. We target cap weighting because the vast majority (over 80% over the last 10 years) of the S&P 500 Index returns, for example, stems from the tops 25% of the securities. I am sorry, but I do not call that a broad market. Also, we target fundamental weighting because fundamental does not typically represent the broad market due to its value tilt.

Why is security volatility weighting better than focusing on low-volatility?

Low volatility indexing and volatility weighting are completely different. The S&P Low Volatility Index, for example, takes the 100 lowest volatile stocks in the S&P 500 Index and cap weights those stocks. This approach does not represent the broader market and has a strong tilt toward Utilities and value investing. There will be periods of time when you’ll like the performance and periods of time when you won’t like the performance compared to the broader market. The CEMP Volatility Weighted Indexes represent all profitable stocks, whether they have high volatility or low volatility. We just equalize their risk be their weighting.

‘Low volatility indexing and volatility weighting are completely different. ‘

The Index is reconstituted every March and September. What is the idea behind this feature?
The more frequent you rebalance an index the more potential for unnecessary trading cost and taxes. March and September are used for screening rebalancing which will allow ample time for all the companies to report their quarterly earnings.

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