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A recent article on Seeking Alpha by Tim Ayles made an unusual argument (unusual relative to the last few years) for actively managed mutual funds and ETFs. The building blocks of his argument include that active managers failing to “beat their index” does not necessarily matter; he would be ok with a fund that lags if the active manager of the fund takes less risk than the market. He only mentions beta as a means of assessing how much risk a fund takes, but beta is more about volatility, and risk and volatility are not necessarily the same thing. You might have better luck looking at things like Sharpe Ratio, R-squared and standard deviation to better assess how much risk a fund is taking.

That quibble aside, the idea of risk adjusted returns is a crucial element to navigating stock market cycles. I would not think of taking on more risk and volatility than the market as being a bad thing. The better way to think of this would be based on your own tolerance for risk and volatility. John Serrapere used to write articles for IndexUniverse which focused on a concept he called 75-50. The goal of his strategy was to capture 75% of the market’s upside but only 50% of its downside. If successfully implemented, the 75-50 strategy will outperform the market over the entire cycle by a noticeable amount. While I have not personally targeted numbers in this manner, the concept describes what I try to do for our clients.

So while I am fully on board with the concept of risk adjusted returns, I disagree with the idea that index ETFs can’t help here; quite the opposite, in my opinion. Depending on how they are used, ETFs can be part of any targeted portfolio effect. While I believe that individual stocks should be included in a diversified equity portfolio, the following chart of the iShares MSCI Brazil ETF (EWZ) and the S&P 500 is a great example of how the effect that Ayles seeks can be had using volatile, passive instruments.

The economic fundamentals and attributes underlying Brazil are different than that of the US, as is the makeup of the benchmark index in Brazil. This means that relative to many countries, Brazil has a low correlation to the US, as do other markets in the world. This did not prevent Brazil from going down a lot after it peaked in Q2 2008, but of course a disciplined, preplanned exit strategy (heeding a breach of its 200 DMA) could have gotten a holder of this fund out 18% below the peak instead of riding the fund all the way down to a 70% decline before it started coming back.

The above requires understanding the other country, looking under the hood of the ETF for that country and realizing that the volatility can work in your favor (and make no mistake, EWZ is more volatile than the S&P 500). There are countless other examples with other country funds, thematic funds and sector funds with all manner of volatility characteristics. I would describe the above as active management with passive tools, and while this is far from an original thought, it is not how most people use volatilities - that is, blending together different types of volatilities to create the desired effect.

Source: Active Management With Passive Investment Products