Accurate labelling has long been a problem in retail investing. This issue is about to bubble up for ETFs, for two reasons.

In September, investment dealers will be required to begin giving ETF investors a summarized disclosure document called ETF Facts - an ETF version of Fund Facts. Unfortunately, the risk and suitability sections of ETF Facts are as problematic as those in Fund Facts.

A separate but related issue is the method used to classify ETFs as having either actively or passively managed portfolios. This compounds the issue of truth in labelling. Most of what passes for passive ETFs actually are active bets with unique risks not found in truly passive funds and not addressed in ETF Facts.

Having been involved in various fund classification initiatives, I can attest to the fact that there is no perfect method. But there's room to improve the existing process significantly.

An ETF is classified as passive if it has a mandate to track a third-party index; and provided that the underlying portfolio can't really deviate materially from that mandate. Otherwise, ETFs are classified as active. Having reviewed many ETF classifications, this method clearly has many inconsistencies. Take two "low volatility" funds, for example.

PowerShares S&P/TSX Composite Low Volatility Index ETF (TSX: TLV), sponsored by Invesco Canada Ltd., tracks the S&P/TSX composite low volatility index; this ETF consists of the 50 S&P/TSX composite index stocks with the lowest volatility over the past year. TLV posts its holdings daily and is classified as a passive ETF.

BMO Low Volatility Canadian Equity ETF (TSX: ZLB), sponsored by BMO Asset Management Inc., starts with the 100 biggest and most liquid TSX-traded stocks, then selects the 40 lowest-beta stocks. There is no third-party index provider; BMO created its own methodology. ZLB's holdings are updated and posted daily on BMO's website. ZLB is in the active bucket.

Consider the basic pitch of low-volatility investing. Academic research and empirical evidence reveal that less volatile stocks have outperformed more volatile stocks and the broader market. These ETFs use quantitative strategies in an effort to capture this effect and outperform the broad market. Sound familiar? It should.

That basic pitch sounds the same as that of every active portfolio manager I've ever heard. So, not only is this pitch the definition of active management - in my view - but as ZLB and TLV have similar objectives and guiding philosophies, they should both be classified as active.

The Canadian ETF Association (CETFA) and its stakeholders are working to clarify this issue for financial advisors. In the meantime, here's how I look at the ETF (and broader investment fund) universe and how I would design these classifications across three broad categories:

- Actively managed ETFs include those with securities chosen by a team of human portfolio managers: those labelled as "smart beta" (e.g., fundamental indexing, momentum) and any ETF that selects securities using a strategy aimed at absolute or risk-adjusted market outperformance (e.g., equal weighting). In other words, this category includes ETFs that I consider actively managed based on how the underlying securities are selected.

- Quasi-active managed ETFs have broader exposure to a narrow slice of an asset class. To use an extreme example, the new medical marijuana ETF might provide passive access to all stocks in this industry; but buying the ETF can equate only to an active bet. I define this and other narrowly focused ETFs as quasi-active. Despite offering passive exposure to underlying securities, the only way to make use of these products is by making an active investment decision.

- Passively managed ETFs include any broad-market index funds that weight their underlying securities according to market capitalization or float-adjusted market cap. But I'm not overly rigid here. I consider an ETF tracking, for example, the MSCI emerging markets index as passive. But an ETF tracking anything more narrowly focused - such as an index reflecting the BRIC nations (Brazil, Russia, India, China) - is not.

CETFA's online ETF database listed 615 ETFs trading on the Toronto Stock Exchange at the time of writing. The database classifies 62% of ETFs as passive - representing 88% of Canadian ETF assets under management (AUM). My classification method, by contrast, counts only 12% of ETFs (73 ETFs) as truly passive, accounting for 41% of total ETF AUM.

I count 395 active ETFs (vs CETFA's 231) that make up 26% (vs CETFA's 12%) of ETF AUM. CETFA does not consider my "quasi-active" category, which includes 147 ETFs using my method (33% of ETF AUM).

This isn't about whether my classification ideas are better than those now in use; it's about understanding various investment strategies - both on a stand-alone basis and how they interact in a portfolio - and the associated potential risks. Any clarity on this issue will be a big benefit to you and your clients.

Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.

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