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It has been 50 years since the Toronto Maple Leafs won the Stanley Cup. For die-hard fans, the current season is always going to be the “big one.”

Many smart beta and other active management proponents have the same mantra at the beginning of each year, but they likely benefit from a better historical win/loss record than the hapless Leafs (see “Can 10 million monkeys outperform the index?AER, October 2016). Any strategy that does not precisely replicate an index will perform differently (i.e., with tracking error); outperformance will come at the expense of those that underperform.

Leafs fans don’t dwell on the past—that would be depressing. However, looking through the rear-view mirror is something the investing industry does well, and perhaps too often. To what extent does past performance provide clues about the year ahead for alternative strategies?

Few product providers or professionals will tell you, on the record, that funds that outperformed last year will outperform again this year. But, we know this is the easiest thing to sell to retail investors and even to those with experience and sophistication. Professionals must consciously fight the urge to fall into this behavioural trap. Recommending a recent winner will rarely get one fired and such a suggestion takes the least explaining. Pension consultants know that picking a disciplined manager with a good, long-term track record (e.g., who has made no changes to their style, approach or staff, even as they’ve slipped into the fourth quartile in the past year or two), is likely the best choice, ceteris paribus.

But few have the courage to recommend a poor performer because of business risk. Consultants aren’t compensated by how well their managers perform in future years, but by how confident they make their clients feel at the time of a selection. These are different objectives, so be clear which one your client will appreciate in a long-term relationship. In the future, getting investors to their financial goals may demand new compensation models. As fee-based practices grow, advisors will increasingly define success by how they perform for their clients.

Table 1 shows the performance of representative, factor-based ETFs in the Canadian equity space for one- and three-year periods ending December 30, 2016. Asset-weighted returns for 2016 show factor winners: small cap (38.1%), equal weight (30.9%) and value (29.8%). Will you recommend these to your clients next year?

Energy stocks did well, with a bounce in oil from US$26.21 per barrel of benchmark-crude WTI in February to over US$50 per barrel by year end. iShares S&P TSX Capped Energy ETF (XEG) was up 38.9% and the BMO Junior Oil Index ETF (ZJO) gained 42.7% over the year. Materials also performed well, with iShares S&P TSX Capped Materials ETF (XMA) up 40.3%. Energy and Materials accounted for 60% of iShares S&P TSX Small Cap (XCS), and about 40% of PXC and CRQ. Over 30% of FXM and over 36% of XCV is energy and materials.

Table 1: Factor-based ETFs in the Canadian equity space

Symbol MER 1 year 3 year CAG AUM($M)
Growth
iShares Canadian Growth Index XCG 0.05% 6.9% 9.1% $47.80
Asset-weighted factor return 6.9% 9.1%
Value
Powershares FTSE RAFI Canadian Fundamental Index PXC 0.51% 30.0% 7.3% $228.00
iShares Canadian Fundamental Index CRQ 0.74% 29.8% 6.9% $214.40
First Asset Morningstar Canada Value Index FXM 0.60% 19.0% 3.0% $161.70
iShares Canadian Value Index XCV 0.50% 24.9% 6.4% $71.90
Asset-weighted factor return 26.8% 6.1% $676.00
Momentum
First Asset Morningstar Canada Momentum Index WXM 0.60% 8.9% 5.1% $156.90
Asset-weighted factor return 8.9% 5.1%
Equal weight
BMO S&P/TSX Equal Weight Industrials Index ZIN 0.61% 31.4% 3.8% $30.60
Horizons S&P/TSX 60 Equal Weight Index HEW 0.50% 29.5% 7.3% $11.90
Asset-weighted factor return 30.9% 4.8% $42.50
Low volatility
BMO Low Volatility Canadian Equity ZLB 0.39% 13.0% 14.3% $1,295.10
PowerShares S&P/TSX Composite Low Volatility Index TLV 0.33% 15.4% 10.3% $268.60
iShares Edge MSCI Min Vol Canada Index XMV 0.30% 17.2% 9.9% $103.30
Asset-weighted factor return 13.6% 13.4% $1,667.00
Small cap
iShares S&P/TSX SmallCap Index XCS 0.55% 38.1% 5.2% $141.30
Asset-weighted factor return 38.1% 5.2%
Canadian Stocks: S&P/TSX Composite 21.1% 7.1%

Explaining performance after the fact is easy, but does little good for investors next year. Past performance doesn’t predict future performance, with the occasional exception of top decile performers that may get some momentum into a second year. Otherwise, keeping costs low is the best strategy, writes Mark Carhart (see “On Persistence of Mutual Fund Performance,” Journal of Finance, March 1997).

A curious study of the impact of trailing commissions suggests that good performance leads to higher positive fund flows when compensation is not considered. The paper, commissioned by the CSA (“A Dissection of Mutual Fund Fees, Flows and Performance,” Oct. 2015), makes the unusual conclusion that managers with these higher flows have a greater incentive to outperform than those with weaker fund flows. The paper shows that investors buy last year’s performance, and implies that this is a good thing! While the views of the paper’s authors do not reflect those of the regulator, the difficulty in overcoming the mental shortcut of picking last year’s winners is clear when even well-meaning academic papers lead to misguided conclusions.

Leafs fans argue that rookie depth—think Matthews, Marner, Nylander, Brown, Hyman and Zaitsev—producing at a high level (i.e., one third of total points of the top 20 rookies in the NHL), combined with strong performances from veterans like van Riemsdyk and Kadri, bode well for future performance. Investment managers and advisors can learn from these fans that prospective victory depends on current asset performance in the context of the capital market environment. Strategy should be determined by what will deliver a win when it counts, like at retirement. Dwelling on past success should be considered with this in mind: Are smart beta strategies worth their higher cost? If you have a strong view about future trends, go for it. Otherwise, stick with diversification, risk control and low costs—the keys to winning in the long run.

Mark Yamada is President of PÜR Investing Inc., a software development firm. Disclosure: PÜR Investing Inc. provides risk-based model portfolios to Horizons ETFs.

Originally published in Advisor's Edge Report

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