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Smart Beta vs. Active Management

ETFs were first created as passive investments – vehicles with low fees that tracked a particular index and provided market returns and market risk. In the 30+ years since the first ETF was launched, we have seen an expansion of offerings. Now investors can purchase ETFs that track indices in China, Brazil, really anywhere.  However, another popular trend has emerged since 2008. Realizing the popularity of the ETF, the transparency that it provides and its low cost, asset managers started to introduce Smart Beta ETFs that would not merely track an index but try to beat it. This was done by overlaying rules or factors on top of indices. Soon after the ETF market fragmented further with new ETFs tilting towards Quality companies (based on certain fundamental metrics), Dividend Payers or Low Volatility.

For the most part, these ETFs have been mechanically driven – computers running models and executing changes to the ETF portfolios as the models change.  What has yet to really be explored in the ETF space is truly actively managed strategies within the ETF vehicle – portfolios that are not run by models but by humans, the way Mutual Funds have typically been managed. The shortcomings of a model are that they are very rigid and can be slow to react.  As an example, a Smart Beta ETF that reviews and rebalances its holdings quarterly might hold a name whose fundamentals have deteriorated for longer than an active manager – much to the detriment of the investor. As they wait to feed new information into their model, the active manager has been able to assess an issue in real time and adjust a portfolio accordingly.  These types of situations are particularly damaging in Black Swan type events.  For example, the Equifax data breach or the Emissions scandal at Volkswagen. Often the tactical nature of active management can provide better returns and sounder risk management, significantly outweighing the potential savings of picking a rules-based strategy.

This post is presented for illustrative and discussion purposes only. This post should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities and it does not consider unique objectives, constraints, or financial needs of the individual. Under no circumstances does this post suggest that you should time the market in any way or make investment decisions based on the content. Investors are advised that their investments are not guaranteed, their values change frequently, and past performance may not be repeated. References to specific securities are presented to illustrate the application of our investment philosophy only, do not represent all of the securities purchased, sold or recommended for the portfolio, and it should not be assumed that investments in the securities identified were or will be profitable and should not be considered recommendations by Bristol Gate Capital Partners Inc. The information contained in this post is the opinion of Bristol Gate Capital Partners Inc. and/or its employees as of the date of the post and is subject to change without notice. Every effort has been made to ensure accuracy in this post at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and Bristol Gate Capital Partners Inc. accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. We strongly recommend you consult with a financial advisor prior to making any investment decisions. Please refer to the Legal section of Bristol Gate’s website for additional information at www.bristolgate.com.

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