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strategy lab

Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can view his model portfolio here and read more in the series online here.

Investors are a lot like gold panners. Whispers about a profitable bend in the stream bring caravans to its shores. Such is the case with ETFs that claim to beat the market. Some people call them "smart beta" exchange-traded funds. Others call them "factor based." I call them popular.

A Canadian firm, First Asset, offers smart beta ETFs. During the past year (ended April, 2015) assets under management swelled 91 per cent. That compares with a 26.2 per cent growth for the Canadian ETF industry. Research Affiliates is a U.S. firm that creates "fundamental indexes" – a different kind of smart beta fund. Their popularity, too, has grown faster than bamboo. John West is Research Affiliates' managing director and head of client strategies. He says assets under management increased 36 per cent per year over the past five years. By comparison, the global ETF industry grew by 20 per cent annually.

First Asset launched its Morningstar International Value (VXM) and International Momentum (ZXM) ETFs last November. The company says that if these ETFs were available 15 years ago, they would have turned $10,000 into $46,370 and $46,779 respectively from Dec. 17, 2000, to Oct. 31, 2014. The MSCI cap-weighted index would have turned the same $10,000 into just $14,170.

First Asset claims equally incredible backtested results for its first four ETFs, which were launched in 2012. During the decade ended July 31, 2014, they say the ETFs would have beaten their respective benchmark indexes by an average of 4.17 per cent per year.

Smart investors should ask two questions. How? And are such backtested claims too good to be true?

Most index funds track the market's return. Such plain vanilla products weight their holdings based on each company's respective size, measured by market capitalization. Take the S&P 500. Apple is the biggest company in the United States. So the iPhone maker is the most heavily weighted stock in a S&P 500 index. Cap-weighted indexes are cheap. You could, for example, build a diversified portfolio of iShares or Vanguard ETFs for less than 0.2 per cent per year.

No investment can beat the market if its components and weightings are the same as the market's. So First Asset's smart beta ETFs don't hold stocks in proportion to their market capitalization. Instead, their ETFs hold low volatility stocks in equal proportions. They also seek stocks with low prices relative to earnings, cash flow, sales and book value.

If that sounds like active management, well … it is. According to David Barber, vice-president of national accounts at First Asset, each ETF trades about 50 per cent of its holdings each year.

Their first four ETFs now have three-year track records. They include 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).

But do they really beat the market? Two of them did. Two of them didn't. As a group, their Canadian-equity ETFs averaged 12.88 per cent per year. Compare this with the iShares S&P/TSX Composite Index ETF (XIC). It averaged 10.47 per cent.

First Asset, however, can't kick sand in anyone's face. Their Morningstar U.S. Dividend Target 50 Index (UXM) averaged just 12.9 per cent. The iShares S&P 500 index ETF (XSP) averaged 16.57 per cent.

Theoretical backtests look impressive. But the real world kicks harder than a software program. Canadians investing with Research Affiliates' (RAFI) ETFs also have a few bruises.

In the five years ended April 30, 2015, iShares' RAFI indexes beat their cap-weighted counterparts in the U.S. and international equity categories. But plain vanilla indexes beat them in the Canadian and emerging market categories.

The iShares Canadian Fundamental Index ETF (CRQ) averaged 6.8 per cent. The iShares S&P/TSX Composite Index ETF (XIC) averaged 7.33 per cent per year.

The iShares U.S. Fundamental Index ETF (CLU.C) averaged 17.23 per cent compared to 13.71 per cent for the iShares Core S&P 500 Index ETF (XSP).

The iShares International Fundamental Index ETF (CIE) earned 9.55 per cent. The iShares MSCI EAFE Index ETF [CAD-Hedged] (XIN) averaged 9.18 per cent.

Finally, iShares MSCI Emerging Markets Index ETF (XEM) averaged 5.66 per cent versus 3.81 per cent for iShares Emerging Markets Fundamental Index ETF (CWO).

Smart beta funds might beat the market. They might not. But don't fool yourself. They won't come close to their marketing claims.