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Latest ETFs leave index-trackers in the dust

A pedestrian holding an umbrella walks past an electronic board showing the Japan’s Nikkei average outside a brokerage in Tokyo, Feb. 4, 2014.


Oh, how exchange traded funds have changed. ETFs have evolved from simple securities that track indexes to complicated "smart beta" structures designed to outsmart the index.

"The toolbox of products that are available to investors in the U.S. and Canada have grown phenomenally over the past couple years," says Deborah Fuhr, partner and co-founder of Britain-based ETFGI LLP. Her company researches and consults on a database of 4,700 exchange traded products around the globe with assets topping $1.7-trillion (U.S.).

ETFs have opened up a world of opportunity for retail investors trying to wean themselves off of North American equities and venture into foreign markets – without having to pay huge fees. Ms. Fuhr's advice to investors is to work with their advisers to determine which ETFs will give their portfolios the right amount of exposure to the right geographic regions. "You want to look at where you already have money invested and if you want to put more into those buckets."

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She also suggests subdividing bigger geographic regions such as the United States and Europe based on sector and company size. "When you think about the U.S., do you want broad exposure to large-, mid- and small-cap? Would you prefer just to have large-caps? Would you prefer to have a sector or two?"

In its simplest form, an exchange traded fund tracks an index such as the S&P 500 or Japan's Nikkei. The holdings are market weighted, meaning the ETF holds a portion of a company's shares relative to its market capitalization.

The mother of all global indices is the MSCI ACWI (all country world index). It tracks the biggest companies in the world. Canadians can buy into it like a stock through an iShares fund (XWD), or use the country weightings as a guideline to invest in regions or countries through other ETFs.

There is an ETF for just about every geographic region and sector in the world. Several companies, such as Blackrock iShares and Vanguard, offer ETFs.

That competition has resulted in several exchange traded products that have expanded from the market weighted formula – a term called "smart beta."

"Smart beta is defined as any benchmark that is not market cap weighted," Ms. Fuhr says.

One variation is equal weighted, where every company in an index has the same value in the ETF, giving smaller-cap stocks with more growth potential greater prominence. Other smart beta strategies seek to minimize volatility or focus on criteria more closely tied to the economic fundamentals behind the country or sector.

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"The commonality would be that it's taking a market cap benchmark and reorganizing it based on looking at one or a number of factors. The idea is that in many market cycles, these non-market-cap benchmarks do better than market cap," she says.

Much of Chicago-based fund analyst Morningstar's database is devoted to new smart beta ETFs. ETF strategist John Gabriel says they can get complicated and it is important that investors understand what they are getting into. "It's a little bit more homework because you have to understand the methodology."

One methodology gaining popularity is RAFI, which is based on four fundamental factors for selecting companies in an ETF: sales, cash flow, book value and dividends. "They will give each company a weighting according to those four factors. The company gets a weighting equivalent to its economic footprint rather than its market capitalization," he says.

As an example, he says, a smart beta approach could be beneficial in China, where the biggest companies are state owned, and smaller, consumer-related companies with more growth potential hold a bigger stake.

"The state owned companies might not be run in the best interest of shareholders. They may not reflect the economic growth of the country because they have their own mandates, which may be political and not financial."

He says smart beta ETFs are in their infancy and comparing them to market weighted ETF performance can be difficult. "The problem with these strategies is that a lot of them are new and are all based on back-tested strategies because they don't have long histories," he says. "The next 10 years could be vastly different."

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He also warns about smart beta fees. Standard market weighting ETFs normally carry annual management fees of about half a per cent because they are fairly simple to manage. Smart beta funds are normally much higher, and that could eat into returns.

"You want to look at how much you're paying over a market weighted fund to get that kind of exposure, and whether it's worth it. If you start getting way above, that's a red flag," he says.

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