How hybrid ETFs blend the best of both worlds

Certain types of ETFs provide investors with both passive and active benefits

How hybrid ETFs blend the best of both worlds
ETFs are getting more attention from Canadian investors who appreciate exposure to a group of securities without having to pay high fees. However, the traditional structure of an ETF is a simple index-based one, so retail investors don’t have access to the expertise of a seasoned investment manager.

A subgroup of ETFs is emerging to address this issue, according to the Globe and Mail: hybrid ETFs, which incorporate an active element to improve performance or lower volatility compared with traditional passive ETFs.

Hybrid ETFs, which are growing in popularity among Canadian investment advisors, can be generally divided into two types. Smart-beta funds use alternative index construction rules, which usually take into account the size, value, and volatility of the fund’s individual holdings. Unlike an active stock-picking setup, smart-beta funds usually modify weightings using a systematic approach.

Meanwhile, actively managed ETFs are run by a manager or team of experts who make decisions on the portfolio allocation and weightings. Such ETFs are usually based on a benchmark index, but are free to change sector allocations, time market trades, or stray from the index depending on the best judgment of the managers.

“I think, on balance, hybrid ETFs can be better than passively invested ETFs,” Jason Del Vicario, a portfolio manager and investment advisor at Hollis Wealth with Scotia Capital, told the Globe and Mail.

Del Vicario said he favours hybrid ETFs that follow a “strict and understandable” process, but with fewer than 50 holdings; any more diversification, according to him, would be counterproductive. For him, hybrid ETFs are most likely appropriate for investors with the sophistication to understand and seek strategies that go beyond merely chasing after an index.

“There are significant opportunities for investors [in hybrid ETFs],” Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ, told the publication. He said they allow targeted exposure to a small segment of the marketplace and regular rebalancing toward the best opportunities in that sector. “You get the positives of active management but in a rules-based way, taking emotion out of the investment process.”

Rosenbluth said that to mitigate the risks or volatility inherent in the investment style or sector followed by specific hybrid ETFs, they are often used as part of existing diversified portfolios.

What are the downsides of hybrid ETFs? Del Vicario said that the strategies used by these funds could become predictable, raising the possibility of larger investors beating them to the punch in the market and therefore reducing their returns.

Rosenbluth points to a more basic principle: targeting higher rewards entails higher risks. In some cases, simply tracking the underlying sector or index would be more profitable, although Rosenbluth said it could come with more volatility.

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