Investment selection is as much of an art as it is a science. While quantitative risk and return metrics are important, the best advisors also focus on the qualitative side. An important aspect of that is being able to distill the overarching strategy of a portfolio and its individual constituents into an understandable, relatable, and compelling theme for your end clients.
With the mutual fund and exchange-traded fund (ETF) universe growing larger and larger by the day, the prospect of "analysis paralysis" from having to sift through dozens of tickers to construct the right portfolio for your clients can not only be daunting but could also cost you time and money.
How We Got Here: The Evolution of ETFs
The genesis of the ETF industry can be traced back to two distinct developments in the Canadian U.S. markets during the early 1990's.
In the domestic market, the Toronto Stock Exchange (TSX) launched the "Toronto 35 Index Participation Units". Over time, this product morphed into the well-known iShares S&P/TSX 60 ETF (XIU), which is heavily traded by institutional and retail investors alike.
Down south, State Street Global Advisors launched the SPDR S&P 500 ETF (SPY) a few years later in 1993. SPY turned 30 years old on January 22nd, 2023, and is currently the largest ETF in the world in terms of assets under management and trading volume.
From there, the ETF industry grew at an incredible pace. Year-after-year, new ETF products debuted, tracking geographies like emerging markets, asset classes like commodities, and even offering exposure to alternative hedge-fund like strategies such as trend-following and market neutral.
For advisors and retail investors, the dominance of passively managed index ETFs came under fire after severe losses during 2008. While passive strategies boast low costs and track their benchmark indexes tightly, they offer virtually no downside protection. When the market takes a bath, passive ETFs follow suit. Tracking the benchmark index also meant an inability to outperform altogether.
While actively managed ETFs that picked stocks based on a manager's expertise and continuous analysis were around, they were quickly eclipsed by the advent of "smart beta", also known as "factor ETFs". These ETFs represented a hybrid between passive indexing and active management, and quickly gained prominence thanks to their transparency and lower fees.
Smart beta ETFs can be characterized by their use of rules-based, quantitative frameworks that select securities based on empirically proven risk factors or financial metrics. Commonly, these include the Fama-French factors of value, investment, profitability, and size, or others like momentum, dividend growth, and low-volatility.
The Mosaic Solution
Good advisors know that there is no one-size fit all for their clients. Because the investment environment is highly dynamic, portfolio composition must remain agile as well. Here's a high-level breakdown of how active, passive, and smart beta ETFs can shore up each other's weaknesses: