Blurring the lines between active and passive investment management

Strategic beta strategies are often marketed via other names: Smart beta, exotic beta, advanced beta, enhanced indexing etc. Our preferred label of "strategic" dials down the marketing hype, and lumps together different providers who have the common aim of putting a systematic tilt on a portfolio in order to capture a known risk premium or take advantage of a documented market anomaly. In general, we believe that strategic beta investments occupy the middle ground where the bet-against-market (active) and rules-based (passive) approaches intersect.

Morningstar's definition of strategic beta may differ from what might be included under other labels. For example, we include offerings that first screen for certain attributes and where the chosen companies are then apportioned according to their market capitalization (i.e. bigger companies get a bigger weight in the portfolio). Other definitions of this space may not include market-capitalization portfolio construction methodologies.

Strategic beta portfolios differ in a meaningful way from more traditional broad-based indices in that there is a conscious active-management decision made in forming the portfolio's policy. Strategic beta portfolios then revert to a passive approach more akin to the broad-based indices by implementing the portfolio in a systematic, rules-based manner.

There are numerous flavours of strategic beta that we categorize. There are return-oriented strategies which screen for attributes such as dividends, value, growth, momentum, buybacks, quality and others. There are also risk-oriented strategies that attempt to minimize volatility, achieve a low or high beta, or use risk-weighting methods. In Canada, the bulk of strategic beta assets are in return-oriented strategies, with dividend-screened ETFs being the most popular current choice.

As one might guess, the fees charged for these portfolios fall somewhere between the ultra-low costs of broad-based index ETFs (for example, XIC and ZCN, which both track the S&P/TSX Capped Composite Index, have management fees of just 0.05%) and the typically high costs of running an actively managed investment portfolio such as many mutual funds (the average MERs for funds in the Canadian Equity and Canadian Dividend & Income Equity categories are in the 2% range). By comparison, iShares Canadian Select Dividend Index ETF XDV, Canada's largest strategic beta ETF, has a 0.55% MER.

Still small when compared to the trillion-dollars-plus in Canadian mutual funds, the Canadian ETF industry is about $81.5 billion in assets as of the end of February 2015. Of this, about $9.2 billion fits Morningstar's strategic beta definition. Asset growth has been very strong for ETFs in Canada. Net inflows and market effects have combined to raise Canadian-domiciled ETF assets about 67% from three years ago. The strategic beta subset of this industry has shown even stronger asset growth -- nearly double the pace at about 132% (albeit from a much smaller base amount) over the same period.

Globally, almost $400 billion has now been allocated to strategic beta ETFs, so there is significant worldwide interest in investing this way via ETFs. With successful asset gathering comes product proliferation, and we expect to see many such strategies launched in the coming years. Strategic beta products are subject to the normal notes of caution we sound on other investment products: Understand the underlying investment thesis. Look for providers who are good stewards of investor's capital. And, as always, costs matter.

Of special note to strategic beta strategies, the initial active management investment thesis should have a legitimate basis in financial theory and strong supporting evidence of success over multiple time periods in multiple markets.

While historical success provides important support, there can be too much of a good thing. Even long-term successful investment strategies exhibit periods of underperformance. With modern access to computing power and vast amounts of historical investment data at our disposal, it is possible to mine for complicated investment strategies that would have produced impeccable results in the past had they been implemented. No doubt most such strategies will come to market with a successful back test. It is entirely possible that what worked historically may not work in the future, either because the history was a fluke or because too many investors catch on to the anomaly and eliminate its effectiveness.

Nevertheless, investors should make themselves aware of this middle ground which is becoming more readily available. Traditional fans of passive management can look to certain strategic beta products to see if one is a better fit for their risk profile than their current broad index or if another has a believable opportunity to take advantage of a known market anomaly that could be worth the additional costs. Those who invest via traditional active management have a potentially lower-cost alternative in strategic beta products that may cover the same ground as a given active manager, who may not have established a convincing case that his or her ongoing active implementation is helping.

Either way, strategic beta offerings will increasingly be on the radar of Canadian investors.