Index-tracking exchange-traded funds have become one of the fastest growing ways for Canadian investors to gain diverse exposure to the stock market at a low price.
But now, smart beta ETFs are gaining ground as they look to improve on that by using additional criteria such as volatility, valuation, quality and size to limit the stocks held in the fund.
"The problem that they are trying to solve by using smart beta is this idea that when you own all 500 companies in the S&P 500, you know that in that mix there's going to be some that are just not great," said Brent Vandermeer, a portfolio manager with HollisWealth.
"The intent is trying to create a basket that has better performance by filtering out (companies) based on certain criteria ... coming up with a smaller group and getting a better performance out of that smaller subset of stocks."
The Toronto Stock Exchange has about 500 ETFs listed with a total market value of about $130 billion.
Traditional benchmark ETFs track an index and those are weighted by market capitalization, giving the largest companies included the biggest influence. That means if an ETF is tracking the S&P/TSX composite, it is heavily weighted to the financial, energy and mining sectors.
Smart beta ETFs look to improve returns and reduce risk by applying additional rules to decide which companies are included and which ones don't make the cut. The rules are often based on an accounting metric or a stock's volatility.
Vandermeer, who uses ETFs in his clients' portfolios, says he uses smart beta depending on the situation.
"When we've wanted to de-risk the portfolio, but stay invested in the market, we've used low-volatility smart beta ETFs to reduce our risk levels."
He said they can also be used to complement active management.
BlackRock's iShares business, the world's largest manager of ETFs, estimated last year that smart beta ETF assets will reach US$1 trillion globally by 2020, growing at a rate that is double the overall ETF market.
Pat Chiefalo, head of iShares product at BlackRock Canada, says active managers have tilted portfolios to particular kinds of stocks for years.
"What we have the ability now is to do it in a very clear, rules-based methodology and incorporate it into an ETF and offer it at a better price point," he said.
"So opposed to now giving you a plain-vanilla benchmark that would typically be market cap weighted, we can change that portfolio and tilt that portfolio to increase the weighting to value stocks or quality stocks or dividend stocks for that matter."
Chiefalo said it's important for investors to understand what they are buying and suggested smart beta funds may be for those who want to spend a little extra time learning the factors used to construct the funds and how they work.
Smart beta options also come at a cost. Chiefalo said the fees for smart beta are somewhere in the middle of the spectrum, typically more than other traditional low-cost ETF options that track a given index, but generally less than an actively managed fund.
Trading in and out of smart beta ETFs could also boost your costs over a passive investment strategy and there is no guarantee these types of funds will outperform the index.