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Strategic beta ETFs offer a different set of opportunities and risks

By Jade Hemeon |

As the financial markets are flooded with new and more complex exchange-traded funds (ETFs), the secret sauce to investment success will be selecting the highest quality and most suitable ETFs for clients and putting them together in a complimentary manner, a forum on ETFs was told today in Toronto.

One of the primary themes of the forum, sponsored by Toronto-based Morningstar Canada, was the increase in the supply of "strategic beta" ETFs and the accompanying increase in the complexity of the product.

Strategic beta ETFs are built to provide exposure to an underlying portfolio of securities selected through an automated, rules-based process based on a customized set of factors, and they therefore offer a different set of opportunities and risks than plain vanilla ETFs based on traditional broad indices weighted by market capitalization of the underlying securities.

"The market has been pretty well covered off," Yves Rebetez, managing director of ETF research and consulting firm ETF Insight, told the forum, referring to the array of ETFs that cover traditional broad market benchmarks. "Where the opportunity lies is in the utilization of ETFs, which is inferior to the level it could be."

The two other panelists, Ben Johnson, director of passive funds research at Chicago-based Morningstar, Inc. and Tyler Mordy, president and co-CIO of Hahn Investment Stewards & Co. Inc. of Toronto, added that it is becoming more important to look under the hood and examine the various components of individual ETFs. The growing size, geographic reach and complexity of the market are creating opportunities for ETF portfolio strategists who increasingly are being hired by financial advisory firms and institutional accounts to assist in putting together model portfolios for their clients.

"Our firm fundamentally believes that it's easier to add alpha through asset allocation using ETFs, rather than individual securities selection," said Mordy, whose firm relies solely on ETFs in constructing portfolios for clients, making its choices based on assessment of global macroeconomic trends.

According to Morningstar, strategic beta ETFs are still a relatively small segment of the Canadian market, accounting for $8.6 billion of the $78.2 billion in Canadian ETF assets, and they are growing rapidly. However, in making his asset allocations, Mordy said he tends to rely mostly on ETFs that provide plain vanilla market index exposure rather than all the variations offered by strategic beta ETFs.

"Anytime you deviate from a market cap index you are introducing a bias," he says.

For example, he says many of the popular low volatility and dividend-oriented ETFS tend to be overweight in traditional high-yielding stocks such as banks and utilities. This area of the market is becoming a more crowded trade, and therefore one with limited upside.

Mordy said there is a danger in relying on a specialized strategic beta ETF to provide protection in a market downturn. An ETF strategist can instead assess non-correlated ETF opportunities such as moving to bond exposure, or geographic sectors and market niches with different growth drivers.

"Strategic beta just becomes the market if everyone is doing it," Johnson agreed. "And if everyone is crowding into a sector of the market there is reduced opportunity to outperform. Right now, dividend strategies have become popular globally. The capacity of the trade diminishes when there is no longer an adequate supply of investors on the other side of the table to take the other side of the bet."

Mordy says one of the keys in generating returns is to look for contrarian ideas. He often does this by looking for a consensus view, then turning that view upside down to see if there are holes in the argument. Currently, he sees attractive opportunities in some emerging markets, which are being overlooked as many investors are focused on the U.S., a market that is becoming expensive after several years of strong returns.