To this point, much of the tremendous growth in the ETF industry - we now have close to 1,200 U.S.-listed exchange-traded products with aggregate assets approaching $1.1 trillion - has been attributable to “passive” products, those that seek to replicate the benchmark of an index. Several actively-managed ETFs have debuted in recent years, but investor response to these products has been generally muted (there are, of course, some noteworthy exceptions, including PIMCO’s MINT and a number of WisdomTree’s active currency and bond funds).
There are now signs that the active ETF space is finally beginning to gather momentum, and some suspect that this corner of the market will be a major driver of future growth. iShares and Eaton Vance recently received the green light from the SEC to launch active ETFs, sparking hopes that the regulatory “deep freeze” is beginning to thaw.
While true actively-managed equity ETFs have been a bust so far, many exchange-traded products that blur the line between active and passive have experienced great success, both in terms of performance and accumulating assets. The distinction between active and passive ETFs generally comes down to the presence of a target index; funds that seek to replicate an index are passive, while those that seek to outperform a benchmark are active. But there are varying degrees of “passive,” as many ETFs seek to replicate indexes that use quantitative screening methodologies or other techniques to identify a subset of stocks that will outperform the broader equity universe. So while these funds seek to replicate an index - and as such are rightfully classified as passive - it’s important to take a look at the methodology behind the construction and maintenance of the related index to understand exactly where an ETF belongs on the active/passive spectrum.
There are dozens of ETFs that use quant-based methodologies in an attempt to generate alpha relative to broad-based market capitalization-weighted indexes. PowerShares and First Trust are perhaps the best known providers of these products, as each issuer offers a number of market cap-specific and sector-specific ETFs linked to “enhanced” or “intelligent” indexes. There are more than a dozen ETFs in the Quant Methodology ETFdb Category, including several that have accumulated significant assets. Below, we profile three of the more popular options:
PowerShares DWA Technical Leaders (PDP)
This ETF, which has more than $400 million in assets, seeks to replicate the Dorsey Wright Technical Leaders Index. That benchmark is comprised of U.S. stocks that exhibit powerful relative strength metrics, or have a recent history of relative outperformance. The methodology behind the underlying index includes evaluating the 3,000 largest U.S.-listed companies relative to a benchmark index, as well as determining the relative strength of performance for various sectors and sub-sectors.
Given the nature of the underlying index, the sector weightings and individual holdings of PDP can change on a regular basis. Since relative strength depends on recent performance, reversals of trends can lead to a shift in “scores” of the underlying companies. Currently, the fund is heavy in the consumer discretionary and industrials sectors, which combine to account for about 50% of holdings. Not surprisingly, red hot Apple (AAPL) is among the largest individual allocations.
First Trust Large Cap Core AlphaDEX Fund (FEX)
This ETF seeks to replicate the performance of the Defined Large Cap Core Index, a benchmark that is constructed as a sub-set of the S&P 500. The methodology for determining the underlying holdings is both relatively simple and completely transparent:
- S&P 500 components are ranked on both growth factors (three, six and 12-month price appreciation, sales to price and one year sales growth) and value factors (book value-to-price, cash flow-to-price and return on assets).
- Stocks classified solely as growth or value receive their score using the applicable factors. Those classified by S&P between value and growth receive the best score between the factors.
- The stocks are ranked according to score, with the bottom 25% eliminated and the top 75% comprising the index. Those that make the cut are ranked such that the best scores receive the highest weighting.
This straightforward screening system has produced some rather impressive results. The underlying index has performed considerably better than the S&P 500 Index over the last three years. FEX is considerably more expensive than cap-weighted funds such as SPY - this ETF charges 0.70% - but recent returns have justified that cost premium.
Guggenheim Raymond James SB-1 Equity ETF (RYJ)
This ETF is perhaps the best example of the blurring of the lines between active and passive in the ETF space. RYJ is passive in the sense that it seeks to track an index, replicating the Raymond James SB-1 Equity Index. That benchmark is comprised of all equity securities rated Strong Buy 1 (“SB-1″) by Raymond James & Associates. Those ratings are the result of a number of factors, including both quantitative analysis and analyst evaluation, meaning that the composition of the fund is influenced by human judgment (though the same could technically be said for the S&P 500).
RYJ’s composition can change based on the ratings assigned to individual securities and the outlook on specific sectors. Currently, the ETF is heavy in technology and financials. This ETF has also performed quite well compared to traditional cap-weighted products over the last three years, outperforming the S&P 500 by a fairly wide margin.
Disclosure: No positions at time of writing.
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