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strategy lab

Andrew Hallam is the index investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

Quick question: Which are Canada's hottest index funds? Considering the stampede into Vanguard Canada's ETFs since their 2011 debut, many would give them the nod. In fewer than two years, their assets under management exceeded $1-billion.

But there's another fast horse in the ETF race, and it's hot on Vanguard's tail. First Asset launched its first exchange-traded funds in June, 2011. This month, the firm's indexes surpassed $1-billion under management. They were slower out of the gate than Vanguard, but they've made up plenty of ground. During the past 12 months, First Asset's ETFs have increased its assets under management by more than 300 per cent.

"In the first six months of 2014, assets under management in First Asset's factor-based ETFs more than doubled, while total assets in Canadian-listed ETFs grew by about 12 per cent," said David Barber, the company's vice-president of national accounts.

Why such raging popularity? Some are whispering that the firm's nine factor-based ETFs might actually beat the market.

Most index funds are cap-weighted. This means they're designed to track a given stock market, with a greater emphasis on larger stocks. Even a cap-weighted small cap index allocates more money to the largest of the small caps. Cap-weighted indexes are cheap, so they outperform most actively managed funds. You could, for example, build a diversified portfolio of iShares or Vanguard ETFs for less than 0.2 per cent per year.

In contrast, First Asset's factor-based ETFs aren't cap-weighted. Each stock is equally weighted. These indexes also cost more, averaging 0.66 per cent.

They fall under five categories: value, momentum, high dividend, low-risk and blended solutions. Despite costing more than most ETFs, Mr. Barber says they're worth it. "Our products defy the efficient market hypothesis. Studies show our system would have provided better historical returns without taking greater risk."

They follow a strict rules-based strategy. First Asset's Morningstar Canada Value Index (FXM) for example, comprises 30 equally weighted stocks. Each is selected based on low price relative to earnings, cash flow, sales and book value. Fund managers also take earnings estimates under consideration.

Traditional index funds are passive because their holdings aren't typically traded. First Asset's ETFs, according to Mr. Barber, trade roughly 50 per cent of their holdings each year.

Back-tested studies show their strategy handily beats the market. First Asset says that during the past decade, their Canadian value index would have averaged 15.15 per cent per year, compared with the S&P/TSX's composite at 9.03 per cent.

But does theory meet reality? Burton Malkiel, the Princeton economics professor and author of A Random Walk Down Wall Street says no. "There is considerable evidence of 'reversion to the mean,' and periods of excess performance are often followed by periods of disappointing results. … Often real money results differ from those simulated returns demonstrated in academic studies."

Four of First Asset's factor-based ETFs have been available since February, 2012: the Morningstar Canada Value index (FXM), the Morningstar Canada Momentum Index (WXM), the Morningstar Canada Dividend Target 30 Index (DXM) and the Morningstar U.S. Dividend Target 50 Index (UXM). According to the firm's white paper published in July, two of the four (FXM and WXM) are beating broad-based index benchmarks since their inception. But the other two (DXM and UXM) are lagging.

So, will these ETFs run true to historical back-tested form and start beating the market? Based on their current popularity, many people must think so.

First Asset’s factor-based funds versus the market