For years, a raucous debate has raged between proponents of active and passive investment management. Since Jack Bogle’s Vanguard Group launched the first retail index tracker in 1976, most of the skirmishing’s occurred in the mutual fund space.
The proliferation of exchange-traded portfolio products in the early 2000s, however, caused the battle lines to be redrawn. Active mutual fund managers then were faced with competition from institutional heavy hitters such as Barclays Global Investors, the sponsor of iShares ETFs and later by dozens of other investment management firms offering exchange-traded products of their own. Most recently, the circle has closed with the introduction of actively managed ETFs.
There’s just a handful of active ETFs on the market currently, but a battalion awaits registration as investors hunger for market-beating returns. Before getting too excited about the new active offerings, though, alpha-seeking advisors owe it to their investors to check on the existing portfolios’ performance to see what they’ve actually delivered. Have they, in fact, beaten the market? If so, at what cost?
The track records for these products are short, so any attempt at analysis needs to be creative. First of all, weekly rather than monthly data points need to be employed to produce meaningful statistics. In-depth analysis of the entire marketplace is beyond the scope of this article, so we’ll confine our examination to equity products and save the parsing of actively managed debt portfolios for another day.
Given the history of exchange-traded products, we ought to expect the price of active management to be lower in the ETF format than in mutual funds. After all, there’s more overhead in a mutual fund operation. Exchange-traded products devolve shareholder relations onto financial intermediaries while mutual funds interface directly with investors. Higher accounting, record-keeping and investor relations costs are built into mutual fund pricing. As we’ll see, there’s as much variance in active ETF fees as there is among mutual funds.
Active Equity ETF Universe
There are ten products in the universe—the oldest ones launched in April 2008, the most recent floated in October 2010.
The Cambria Global Tactical ETF (GTAA) is a classic active portfolio introduced in October 2010 by Maryland-based AdvisorShares. GTAA is a momentum-following fund of funds that invests in a spectrum of asset classes, including U.S. equities, foreign equities, U.S. bonds, foreign bonds, U.S. real estate, foreign real estate, currencies and commodities. The portfolio is either fully invested in an allocation or defensively goes to cash when momentum for that class reverses from upside to downside. Despite its youth, GTAA makes up more than 70% of the active equity ETF market with $171 million in assets.
GTAA is a reactive portfolio; no effort is made to forecast future market trends or direction. Stylistically, the GTAA portfolio represents the investment approach of the Yale and Harvard university endowments, which attempt to provide equity-like returns through a mix of non-correlated assets.
Another AdvisorShares offering, the Dent Tactical ETF (DENT), is an ETF of ETFs that employs a proprietary model to weight portfolio allocations according to demographic trends. Investable asset classes include domestic and foreign equities and domestic and foreign fixed income together with commodities.
DENT was floated in September 2009 and recently clocked in with nearly $17 million in assets.
Introduced in July 2010, the $12 million Mars Hill Global Relative Value ETF (NYSE Arca: GRV) splits its dollar commitments equally between long positions in attractive global markets and short positions in the least appealing segments. Like the other AdvisorShares portfolios described above, the GRV portfolio is an ETF of ETFs.
GRV’s bogey is the MSCI All Country World Index.
With $11 million in assets gathered since its October 2009 launch by RiverPark Capital, the RP Focused Large Cap Growth ETF (RWG) attempts to outperform the Russell 1000 Growth Index with a portfolio of 20 to 30 issues selected by its Wedgewood Partners subadvisor.
Outperformance of the Nasdaq 100 is the goal of the $10 million PowerShares Active AlphaQ Fund (PQY). AER Advisors submanages the portfolio using a proprietary screening methodology that filters out 50 large-cap Nasdaq-listed stocks from its master list.
PQY was one of the first active equity ETFs launched in April 2008.
The WCM/BNY Mellon Focused Growth ADR ETF (NYSE Arca: AADR) has amassed nearly $9 million in assets since its July 2010 inception and holds concentrated positions in non-U.S. issues. The self-advertised focus of the AADR portfolio is the American depository receipts in the technology, health-care and consumer staples/discretionary sectors.
Large cap isn’t large enough for the PowerShares Active Mega Cap Fund (NYSE Arca: PMA). PMA, last valued with an asset base of just more than $5 million, seeks to outdo the Russell Top 200 Index, a benchmark made up of the Russell 3000 Index’s heaviest-capitalized issues.
PowerShares was first to the active ETF market with PMA and two other products in April 2008.
While PMA concentrates on the largest of the large-cap stocks, the PowerShares Active Multi-Cap (PQZ) screens its candidates from a 3,000-stock universe of domestic and international issues in its quest to outperform the S&P 500 index.
PQZ has yet to break the $4 million asset mark since its April 2008 introduction.
The $3 million Columbia Concentrated Large Cap Value Strategy Fund (GVT) was launched in May 2009 with the objective of bettering the performance of the Russell 1000 Value Index.
With assets wavering midway between the $1 million and $2 million marks, the Columbia Growth Equity Strategy Fund (RPX) is the smallest active equity ETF and is benchmarked against the S&P 500 index.
RPX was floated in October 2009.
Running The Numbers
Analysis of the funds produces some telling statistics. First of all, the weighted average of the funds’ expense ratios shows the bulk of the capital invested in active equity ETFs is managed at rates similar to those charged by mutual funds. If investors pay essentially the same fees for management in the exchange-traded product space as they do in the mutual fund world, they’re right to wonder what advantages the ETFs hold.
Among ETFs’ pluses, there’s convenience, certainly. No dealer agreements are required for the brokering of an ETF transaction, so any investment house can facilitate a trade. ETFs, too, are completely portable, so they can be moved en masse with other assets in an ACAT transfer. ETF prices, too, are transparent, and liquidity is immediate.
But what about performance? Do active ETFs actually do better than their benchmarks?
As a class, the answer is no. Six of the ten funds in our universe here can’t outgun their benchmarks on a risk-adjusted basis. The bulk of the capital invested in active equity ETFs, in fact, earns 3% less per annum than the market bogey (see Figure 1).
That’s not to say that there aren’t market beaters. A couple of standout ETFs earn positive alpha. AADR, the WCM/BNY Mellon Focused Growth ADR ETF, notched a positive reading of 16% with barely more than half of its price movements driven by its MSCI EAFE benchmark. A quarter of the AADR portfolio is currently invested in Swiss issues, so some portion of the fund’s upside can be attributed to the strength of the Swiss franc against the U.S. dollar.
While the Columbia Growth Equity Strategy Fund is small, its alpha isn’t. The RPX fund checks in with an 8% coefficient and a low correlation to its S&P 500 benchmark. That coefficient/correlation combination is no accident. RPX has recently overweighted its exposure to financials–nearly doubling the S&P 500’s allocation—while grossly underweighting energy issues.
The funds’ R squared correlations are especially worthy of note. On average, two-thirds of active ETF price movements can be explained by the gyrations of their benchmarks. Despite the active management within the portfolios, there’s some index-hugging going on. To be sure, there’s variance among the funds, e.g., the PQY PowerShares Active AlphaQ Fund registers an R squared of 83% while the PowerShares Active Mega Cap Fund (PMA) clocks in at only 6%, but most of the ETF money tracks the market at around 69%.
If 69% of a fund’s price action is explained by its benchmark, one could argue that the remaining 31% ought to be attributed to active management. The reality is a bit more complex. Only part of a fund’s return is supplied by active management. Some comes from just being in the market.
Pricing Active Management
Investors and advisors have come to accept the notion that active management is expensive. We’ve seen that the weighted average expense ratio of the ten funds in our universe is 1.29%. Passive management, by comparison, is cheap. Exposure to the S&P 500 index, for example, can be obtained for just 9 basis points (0.09%). Style-tracking ETFs, such as the growth or value splits of the S&P or Russell benchmarks, charge around 20 basis points.
This leads one to ponder the actual cost for the portion of fund returns derived from stock-picking. And, more important, to wonder if investors aren’t overpaying for the portion of fund returns attributable to the portfolio’s benchmark. Ross M. Miller, a risk consultant and finance professor at SUNY Albany, took a novel and mathematically elegant approach to these questions in a 2005 paper, “Measuring the True Cost of Active Management by Mutual Funds.”
Miller claims that the bundling of passive and active management understates a fund’s true expense. He’s devised a method for allocating fund expenses between active and passive management and determines the cost of active management by comparing—through the R squared correlation—an active fund’s expense ratio to that of an index fund tracking the benchmark. Essentially, Miller’s methodology carves out the actively managed portion of the portfolio and applies the expense ratio only to that segment.
Using Miller’s technique, the weighted average expense of our ten-fund universe jumps to 2.31%, 1.8 times higher than the published rates (Figure 2). That shouldn’t be surprising, given that 42.9% of the portfolios are actively managed. There are outlier funds, though, that are run more aggressively, namely the Mars Hill Global Relative Value ETF (GRV) and the PowerShares Active Mega Cap Fund (PMA), each with more than three-quarters of its returns attributable to stock picking.
The outcomes of active management differ greatly for these two funds, a fact reflected in their disparate alpha coefficients.
Pricing the funds’ alpha in terms of their active expense gives you a quick way to assess the cost efficiency of each manager’s style and make head-to-head comparisons.
Most of the capital managed in active ETFs is now being dinged for negative alpha. The weighted average active ratio—the quotient of a portfolio’s alpha coefficient and its active expense—is negative 1.32%, clearly reflecting the performance of the category heavyweights, the Cambria Global Tactical ETF (GTAA) and the Dent Tactical ETF (DENT). Together, these two funds account for more than three-quarters of active equity ETF assets.
Four smaller funds have managed to wrest positive alpha from the current market, but at greatly varying prices. The best performer—the WCM/BNY Mellon Focused Growth ADR ETF (AADR)—racked up a 16% alpha, resulting in a 6.93 active ratio. Second best was the tiny Columbia Growth Equity Strategy Fund (RPX), which produced its 8% alpha for a cost of only 1.36%. Though RPX’s alpha was just half that of AADR’s, the smaller fund’s active ratio was nearly equivalent, owing to its lower expense.
So what does all this mean? Well, apparently small is better in the world of active equity ETFs. At least for now. There’s, of course, no guarantee that these portfolio statistics will hold in the future. It’s not likely, either, that these funds are appropriate for every investor’s portfolio. With the sled load of active portfolios awaiting registration, there’s bound to be more choice for investors and advisors in the future. But, to paraphrase a former U.S. defense secretary, you build portfolios with the funds you have, not the funds you want to have. If you have to plug a portfolio hole with an active equity ETF now, you at least have the means to evaluate its true cost.