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Hybrid ETFs may offer the best of both worlds

The two main kinds of hybrid funds are smart-beta funds and actively managed ETFs.

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Exchange-traded funds are gaining an increasing share of the Canadian investing market. The main reason for this rising popularity is their straightforward value proposition: They provide market exposure with very low expenses and easy buying and selling.

The main criticism of ETFs is their mechanical nature – they are usually designed to simply mirror a specific market index, so they do not benefit from the expertise of an experienced investment manager.

However there is a growing part of the ETF universe designed to address this criticism, and potentially give investors the best of both worlds.

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Hybrid ETFs modify the straightforward, passive tracking of an index (or other strictly defined mandate) used by most ETFs. This usually involves some level of active management. The goal is to improve performance or reduce volatility compared with passive ETFs.

The two main kinds of hybrid funds are smart-beta funds and actively managed ETFs.

Smart-beta funds usually use alternative index construction rules, in a transparent way. Their modifications are typically based on the size, value and volatility of the fund's components. It is important to note that smart-beta funds typically use a systematic approach to modifying the weightings in their funds based on these factors, rather than an active stock-picking setup.

Actively managed ETFs, on the other hand, have a manager or team making decisions on the underlying portfolio allocation, or otherwise not following a passive investing strategy. An actively managed ETF will usually be based on a benchmark index, but managers may change sector allocations, market-time trades or deviate from the index as they see fit.

Many Canadian investment advisors have become fans of these types of funds.

"I think, on balance, hybrid ETFs can be better than passively invested ETFs," says Jason Del Vicario, a portfolio manager and investment advisor at Hollis Wealth, a division of Scotia Capital.

He likes the hybrid approach because a rules-based approach to investing can produce superior returns. He favours hybrid ETFs that follow a "strict and understandable" process, but with fewer than 50 holdings, as he feels any further diversification is counterproductive.

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Mr. Del Vicario says ETFs work well for investors who don't have the knowledge, time or desire to actively manage their own money, but want to tap into professional money management and achieve a level of diversification. He feels hybrid ETFs are most likely suited to investors who have a level of sophistication to understand and seek out strategies which go beyond mimicking an index or sector.

Todd Rosenbluth, director of ETF and mutual fund research at CFRA Research, also sees some advantages in hybrid ETFs.

"There are significant opportunities for investors, because you are able to get targeted exposure to a specific slice of the marketplace, and have it regularly rebalanced for the best opportunities in that sector," he says. "You get the positives of active management but in a rules-based way, taking emotion out of the investment process."

Mr. Rosenbluth notes that hybrid ETFs are often used as a complement to existing diversified portfolios to mitigate the risks and volatility of the sector or investing style the ETF tracks.

There are two hybrid ETFs that Mr. Rosenbluth favours and they both offer Canadians an attractive way to gain exposure to the American market. The first is the ishares Minimum Volatility USA ETF, which trades on the New York Stock Exchange. The fund is designed to track the performance of the U.S. equity market, but with less volatility. "It's a great core holding for those who want equity exposure but want protection to the downside," says Mr. Rosenbluth.

His second pick is the Goldman ActiveBeta U.S. Large Cap Equity ETF, also trading on the NYSE. This fund focuses on American blue-chip stocks, with a focus on good value, strong momentum, high quality and low volatility. It also has the advantage of having one of the lowest expense ratios on the market (0.09 per cent).

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Mr. Del Vicario's top hybrid ETF picks reflect his investing philosophy. "We seek companies with consistently high return on equity metrics," he says. "Those that can produce high ROE consistently over time usually have a competitive moat around their business – something that prevents competitors from entering their sector and whittling down their margins over time."

On that note, his first pick is the VanEck Morningstar Wide Moat ETF, trading on the NYSE. The fund is designed to track an index of companies with sustainable advantages, according to Morningstar's equity research team.

For a Canadian hybrid ETF, Mr. Del Vicario favours the BMO Low Volatility Canadian Equity ETF. This fund has been designed to reflect a portfolio of stocks with low sensitivity to market movements. Mr. Del Vicario notes many high ROE companies in Canada also have relatively stable stock prices, so the fund is a sort of a proxy for investing in high-moat companies in this country.

As far as the drawbacks of hybrid ETFs, Mr. Del Vicario points to the possibility that the strategies used by these funds will become predictable and some large investors could disrupt the market by purchasing stocks before the funds do so, and therefore reducing the funds' returns.

Mr. Rosenbluth has a more basic caveat: There is no guarantee the fund's modification will actually mean improved performance. In some cases, simply tracking the underlying index or sector can be superior, though it may come with more volatility.

Editor’s Note The firm CFRA Research was referred to by its old name, S&P Capital IQ, in a previous version of this article. This is the corrected version.
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