ROUNDTABLE: THE SEISMIC SHIFT FROM BETA TO ALPHA
Previously, the onus to generate Alpha was squarely on the shoulders of the advisor as he utilized the Beta products the industry provided. Now the industry is prepared to shoulder the burden as evidenced by the amount of actively managed ETFs in development.
- What is the distinction between actively managed indexes and actively managed funds?
- How are absolute return and 130/30 strategies provided for within the ETF structure?
- Will these products take the place of, or complement, core holdings?
ROUNDTABLE: DELIVERING ON THE PROMISE OF ALPHA VIA BETA EXPOSURE THROUGH SECTOR INVESTING
Many advisors rely on the ability to over/under-weight sectors in order to deliver Alpha for their clients. We will elaborate on the various characteristics that define the broad array of sector funds.
- How does one differentiate between economic sectors and industry classifications?
- What are the merits and constraints of established classification providers versus niche providers?
- What are examples of the strategies advisors can employ?
It's no surprise that investment industry events are having a lot of discussions related to both alpha and beta. Everybody wants to have the beta exposures during the long and steady bull market but with the volatility and downward pressure over the past nine months or so, the talk is all about minimizing the pain. Another session (following the 2nd one above) is titled “Preserving Capital While Pursuing Non-Correlated Returns With Fixed Income ETFs” so I suppose the common theme here is using beta (ETFs) to deliver some broader form of alpha (not at the “group of stocks in a particular asset class” level but at the broader asset mix level).
The question one must ask is whether this type of outperformance, whether in down markets or, generally speaking, delivered by tilting and/or actively rebalancing a portfolio based primarily or exclusively on ETFs can generally be described as alpha? I’d say a definite “yes.”
Well, I think it truly is alpha if you’re really doing something different, and I’ve already outlined in my recent interview with IndexUniverse.com what I think about defining alpha and beta. Now that we’re in the middle of a serious down market, the kind of which we haven’t seen since 2000-2002, it’s interesting to see the timing related to what is now happening in the ETF industry. More rules-based approaches and now even further in that direction … certainly the big topic of the ETF conferences … full blown active management. In my mind, the questions to ask are:
- What sort of actively managed ETFs will we see and will they provide value to investors?
- Will they, in aggregate, gather significant assets under management within the first few years?
To me, if the vast majority of actively managed ETFs are nothing more than mutual fund-type mandates listed on an exchange, I’d be very disappointed. My guess in such a situation is that investors would not find much value there even with a significant reduction in management fees, and furthermore when considering the various additional fees found in mutual funds but not in ETFs. But that’s not the real problem.
The ETF industry has its origins in classical indexing, something more akin to benchmarking than what may be considered an investment strategy. It just so happens that market cap weighted indexing seems to do very well versus a broad array of active managers who, for whatever reason, are constrained by various measures such as a limitation on how much cash to hold, the inability to short securities, etc. For decades, the indexing and then the ETF industry have espoused the benefits of low cost, broad diversification, tax advantages and various other arguments for passive management. Now the ETF industry is simply going to add the active management chant? I’m not so sure if the chorus will be in harmony. But should it? I don’t think it has to - no one said the ETF industry is supposed to be only about indexing. Fundamental indexing and inverse ETFs are examples of pushing the boundaries within the ETF marketplace.
Perhaps what we’ll find are a relatively large number of small ETF providers focused on active management strategies along with a smaller number of large ETF providers (PowerShares would be the obvious example) competing with them. PowerShares and a few other existing ETF providers have never shared the same arguments of indexing and passive management as Vanguard, BGI and State Street have. With fundamental indexing and other rules-based strategies, as well as various thematic (water, cleantech) and unique sector exposures (nanotechnology), there seems to be a logical progression for PowerShares to move into pure active management.
To be fair, it should not come as a surprise for anyone familiar with BGI and State Street’s institutional businesses to see them come out with actively managed ETFs as well. For those who know, both BGI and SSGA run alpha-oriented programs (I don’t know if they call them hedge funds) and even run them along with the beta mandates - for example in portable alpha programs. Somehow, I see these behemoths taking a “wait and see” approach to recent regulatory developments. On the other hand, in an earlier post, I speculated on how the global reaching investment banks would be a logical provider of alpha-oriented products in the form of ETFs.
Getting back to my main argument, let’s move beyond the ETF provider and to the ETF user. Let’s take financial advisers and investment counselors since they are a large and growing group among ETF users. For those in this group that have made ETFs a staple in their portfolio construction process, I believe they all have a common set of themes. It likely revolves around the limited role of manager selection, securities selection and market timing. They likely focus on fairly basic strategic asset allocation and an even greater focus on the use of the most vanilla of ETFs as core holdings. Depending on the type of client, they may also employ significant use of mutual funds from either Vanguard or Dimensional Fund Advisers, if not both.
Do you think many of these advisers use actively managed funds? I’ll bet many if not virtually all of them do. A more important question to ask is what proportion of their client portfolios are weighted towards active funds versus passive funds. For the many pro-ETF users globally that I know, the use of actively managed funds is rather limited. Thus, I don’t see them getting excited about actively managed ETFs as a replacement or even an improvement over mutual funds. The same is true in my opinion for the do-it-yourself investor. Are the advantages of the ETF structure over the mutual fund so great that one would use the Fidelity Magellan ETF over its existing mutual fund counterpart?
I believe that the vast majority of investors who will get into actively managed ETFs will already be very familiar with existing (passively managed) ETFs. They’ve been bombarded for quite some time on the benefits of ETFs and the “evils” of active management. Let me be clear: I’m not against active management, I just don’t think that building an actively managed ETF with an underlying active strategy typically found in a mutual fund will do well. The typical ETF investor knows too well the difficulties for a US large cap equity fund manager to beat his or her relative benchmark. So what do I think might be a better approach?
What we’ve seen in recent years is the ETF industry’s move towards alternative asset classes and themes. We’ve recently seen the introduction of an international inflation indexed bond ETF. Commodity related ETFs have come to market in such an intense wave the likes of which I haven’t seen since Nasdaq related products in 1999 and 2000 (market top signal?!). Part of this is chasing the hot market but part of it is also an attempt to cover new ground in terms of capital market exposures not yet “ETF’d”. Ideally, these new markets (frontier markets, carbon credit markets, etc.) may have great diversification properties, although the ability to turn them into ETFs may be difficult logistically at this time.
Perhaps the successful actively managed ETFs will be those that continue this trend of providing some uncorrelated or risk-focused approach as an “add on” to what most ETF users already have. I suppose what I’m saying is that actively managed ETFs may be looked upon by the majority of existing ETF users as the “satellites” to a fairly basic “core-satellite” approach. And the core? Check the stats for AUM in the ETF industry and it’s the standard names - SPDRs (NYSEARCA:SPY), iShares MSCI EAFE Index (NYSEARCA:EFA), NASDAQ 100 Trust Shares (QQQQ), iShares MSCI Emerg Mkts Index (NYSEARCA:EEM) - providing broad exposures.
From the tables provided in this Street.com article, it seems that investor attraction to these traditional core products is solid. It even surpasses the 80-20 rule. From what I can see, nearly 80% of total ETF assets are in the top 10% of ETFs. At the extreme, we find that 93.6% of total ETF assets are in the top 25% of ETFs. That means 6.4% of total ETF assets are in the bottom 75% of ETFs. This table from Street.com says that the aggregate net assets for ETFs are at $561.4 billion and that there are 649 ETFs.
Breaking out my calculator, I find that 6.4% of $561.4 billion is $35.9 billion. And 75% of 649 is 487 (rounded to the nearest whole number). That means that there is $35.9 billion in the bottom 487 ETFs. Thus, there’s $0.074 billion on average per ETF, and assets under management of $74 million on average per ETF in the bottom 3/4 (based on size). It would be interesting to see the dispersion of AUM over these 487 ETFs. What percentage of these funds have AUM under $20 million and can they survive for long at this level or less?
Clearly, it’s tougher to really hit a home run in the current ETF marketplace. The concentration of assets within a relatively small number of very large ETFs tells us something especially when you go down the list. Aside from gold (NYSEARCA:GLD), China (NYSEARCA:FXI) and Brazil (NYSEARCA:EWZ) in the list of the 25 largest US domiciled ETFs, everything else is fairly stock or bond index ETFs. Still, we see that a few new offerings from truly unique providers like ProShares seem to be making their mark and there will certainly be those in the actively managed space who will find similar success. But they’ll have to do something even more unique to get the interest of investors. I have a few ideas on what they might be.
Broadly speaking, I think they’ll have a philosophy similar to the general hedge fund mantra: market neutral or very low correlation to markets. Or perhaps some sort of “Black Swan” effect to help during times of extreme market distress (not just a VIX ETF). The imagination of Wall Street never disappoints so we’ll just have to wait and see what they deliver. But again, providing a mutual fund in ETF form … well, we’ll just wait and see if that idea works but my guess is that in 3 years we’ll find that:
- The split between the ETFs of today (index and rules based) versus truly actively managed ETFs will be somewhere like 90% to 10% respectively at most. The wild card might be actively managed closed end funds that convert to an ETF structure but even then, I still believe the far heavier weighting will fall to the more traditional ETFs (non actively managed) of today.
- Of the actively managed ETFs, I think the largest ones will be some sort of multi-asset class strategy as opposed to a single asset class strategy which fits in some form of fund classification (like Morningstar’s). This would include “ETFs of ETFs” which for some reason seems to be an idea that I think will catch on well and become a highly competitive arena.
- Although I don’t believe hedge fund managers will use an ETF format to gather assets, I think that some similar strategies (hedge fund replication, 130/30) will find their way in. Further evidence of my alpha/beta convergence theory is mentioned in recent posts.
- I wonder if the tax advantages existing today for ETNs will continue and if so, whether underlying actively managed derivative-based strategies would be employed. I believe that high frequency derivatives trading is generally treated as income and I wonder if wrapping it in an ETN provides a delay for the realization of a taxable event for investors.
Lawyers and accountants are likely having many conference calls with ETF providers these days over the recent news regarding actively managed ETFs. These participants will help drive the ETF industry in one of several ways. Some of these paths I foresee leading to similar difficulties now found in the mutual fund industry. Others do not but lead to other problems.
It will certainly be interesting to see how things develop in this next stage in the industry’s evolution. One thing’s for sure: With the recent news of potential streamlining of ETF filings with the SEC as well as the introduction of actively managed ETFs, just think of floodgates opening. Any commentators complaining of too many ETFs better start resting well and taking their supplements … they're likely going to be shouting the same from rooftops by the end of this year.