The search for outperformance

These approaches—fundamental, equal weight, low volatility, factor-based—are active strategies. Some proponents use terms like “smart beta” or “fundamental indexing,” but make no mistake: these are active strategies that often come with higher costs. Notwithstanding, these approaches are interesting and thought-provoking.

Active versus passive…still

Fans of active management believe beating an index return is not only possible, but can also be done consistently over time. They point out the impossibility of outperformance when the goal is market return, and claim that cap weighting rewards companies whose securities have done well in the past, while saying nothing about the future. This results in overvalued stocks having a disproportionate weight, leaving undervalued stocks under-represented.

Fans of passive management believe replicating market performance at low cost is a better use of resources. Those advocates may also concede outperformance is possible, but that identifying managers who will do well beforehand is almost impossible.

The math on the passive camp’s side is impressive; total performance is the sum of all market losses and all gains less costs, suggesting the market return is the best we can expect in the long run, and managing costs is the one thing investors can actively control. Further proof is that most active mutual funds underperform their benchmarks after fees: 98% of funds in the U.S. versus the S&P 500, and 70% of funds in Canada versus the S&P TSX Composite Index fall short for the five years ending June 30, 2013, according to data from S&P Dow Jones Indices.

These taunts get lobbed back and forth like snowballs in a schoolyard. Investors hear the loudest claims. The growth of alternative strategy ETFs has served to expand the playground. What’s really happening and what should advisors do about it?

Classic passive

Cap-weighted ETFs replicate indices according to the capitalization of the component companies. Institutional investors looking for exposure to an asset class find total market exposure most efficient. Large cap domestic equities in the U.S., or broad fixed income in Canada, are particularly difficult classes in which to outperform, so many institutions take a passive approach.

Using income and balance sheet screens, fundamental indices have produced, for some periods, portfolios with higher returns. The table (see “Comparing fundamental ETFs,” this page) shows two fundamental ETFs, two value ETFs and a baseline equity
index fund.

Comparing fundamental ETFs

As of January 31, 2014

	Ticker	MER	YTD	1 Year	5 Year
iShares Canadian Fundamental Index	CRQ	0.72%	-0.29%	11.99%	14.81%
Powershares FTSE RAFI Cdn. Fundamental	PXC	0.50%	-0.14%	12.4%	N/A
iShares Dow Jones Canadian Select Value	XCV	0.55%	-1.16%	11.36%	15.89%
First Asset Morningstar Canada Value	FXM	0.62%	0.36%	21.7%	N/A
iShares S&P TSX 60 Index Fund	XIU	0.18%	0.51%	11.19%	11.36%

The fact that fundamental indexing represents a value tilt is not a revelation, but investors should know what they are buying. Fundamental indexing is an active strategy that can require more rebalancing than a cap-weighted strategy, so may incur more turnover and commission expenses. For those who believe in value investing, these ETFs may be for you—but be aware that other value ETFs like XCV and FXM are available.

Analysis

If you believe cap-weighted indices overweight overvalued securities, and underweight undervalued ones, you subscribe to the central value theory: all securities are mispriced and fluctuate around their true central values.

Many institutions believe the market is the final arbiter of value. Market exposure means access to the growth and risk characteristics underlying the economies, sectors or industries represented by
index components.

They may take active bets elsewhere in their portfolios, but not in stock selection. Do alternative strategies truly work? The answer depends on what the investor is trying to achieve. Striving to outperform—as controversial as it sounds—is not always the
right focus.

Managing the risks that influence returns is often more fruitful. An evolved investor understands these issues and how to use the new tools best.

In coming months, we’ll examine equal weight, low volatility and factor-based strategies.