So Far So Good: Active ETFs Open with a Bang

By Murray Coleman

The first active stock exchange-traded funds have passed their three-month anniversaries. And along with other more active ETFs on the market, they've been handily beating their passive indexing rivals.

"Obviously, it's a pretty short time period to consider the past three months as a valid data set," said Ed McRedmond, Invesco (IVZ) PowerShares' executive vice president of portfolio strategies. "But it's an encouraging sign starting right out of the box."

Two of the first active ETFs that launched in mid-April are run by AER Advisors for Invesco PowerShares. The advisory firm uses a quantitative-based methodology for developing so-called "Alpha" rankings on stocks. The criteria used include factors such as strong earnings growth, low valuations and positive money flow.

"We're getting an abundance of stocks that look attractive, which is an indication that the market's trading cheap right now," said David O'Leary, chief investment officer at AER Advisors.

That's proving quite beneficial for investors in the PowerShares Active Alpha Multi-Cap Portfolio (NYSE: PQZ). In the past three months through Aug. 1, it had lost 5.90% vs. the 10.2% drop by the S&P 500 tracking SPDRs (AMEX: SPY).

Since PQZ has a mandate to range where it wants, McRedmond suggests that a better way to measure its performance is to compare how actively managed multi-cap mutual funds are weathering conditions. Along those lines, the average multi-cap core mutual fund lost 9.20% in the past three months through Aug. 1, according to Lipper data.

"We're using the 2,000 largest stocks by market cap size," said O'Leary. "So we've got a flexible universe that we update every week. That gives us an advantage over the indexes that are basically stuck in a group of stocks."

PQZ is over-weighting energy (25.8%), tech (27.8%) and materials (17.53%). It's significantly under-weighting industrials (2.86%) and financials (9.49%). The ETF also doesn't hold any consumer names.

"We can change up to three stocks a week on a 50-stock portfolio like the one we use with PQZ," said O'Leary.  "But that's a self-imposed limit. If you actually changed three stocks per week over the course of a year, that would be over a 300% turnover rate."

While he says PQZ's portfolio has shown much less churning of names than its maximum range, "our ability to eliminate lagging stocks when needed has been the key this year."

Another active ETF that came out in mid-April is the PowerShares Active Mega Cap (NYSE: PMA). It's run by parent Invesco's institutional fund managers. Their favorite 30 or so mega-cap stocks go into the portfolio, which uses the Russell 200 as its benchmark. Unlike the AER-managed funds, PMA can trade as necessary, although PowerShares has said that it anticipates executing trades only on a monthly basis.

PMA had returned -8.3% in the past three months heading into August. At the same time, the Russell Top 200 index was down 8.79%. Interestingly enough, the Russell Top 50 index -- an even closer fitting benchmark -- had lost 9.29% in that period.

While the Russell indexes have been big into financials and consumer discretionary, PMA holds much less of both. As a result, the fund's top 10 stocks, which make up more than 56% of its holdings, vary widely. Absent from the ETF's leading names are General Electric (GE), AT&T (T), Chevron (CVX) and Proctor & Gamble (PG). Instead, PMA has stocks such as Hewlett-Packard (HPQ), Verizon (VZ), Occidental Petroleum (OXY) and Medco Health Solutions (MHS).

The new PowerShares are the first to receive regulatory approval as actively managed ETFs. But some other funds are also quite active and doing very well when compared to more passive competitors.

One is the SPA MarketGrader 40 ETF (AMEX: SFV). Its underlying index rebalances quarterly based on fundamental factors. MarketGrader's analysts break down a company's financial picture into four different areas - growth, value, profitability and cash flow. They come up with ratings, which consider metrics such as: EPS growth, earnings surprises, net income, book value, price-cash flow, sales, operating margins, return on equity, annual cash growth and return on invested capital.

"We calculate the rating for every company every day. But it takes a significant price change or earnings report to effect fundamental grades," said Carlos Diez, president of MarketGrader.com Corp., SFV's index provider.

During its latest rebalancing in May, SFV's main sector changes came within industrials (which doubled) and tech (up to the maximum 30% weighting).  Its index's turnover rate also jumped to 72.5%, up from its historical average of around 50%.

With such a concentrated portfolio of 40 stocks, SFV has set some requirements. It's required to have a 25% minimum position in large-caps and a 25% maximum position in small-caps. That tends to make it look somewhat like a mid-cap growth fund. But with such a broad mandate and an equal-weighted portfolio, that's not an exact comparison either. And its aim is to beat the S&P 500 index.

By most any view, SFV is cleaning up. Consider that in the past three months through Friday while SVF was down 1.8%, the passive Vanguard Mid-Cap Growth ETF (AMEX: VOT) had lost 8%-plus. Even compared to the Rydex S&P Equal Weight ETF (AMEX: RSP), which has lost more than 10% in that same period, the MarketGrader 40's recent performance looks strong.

Other MarketGrader ETFs using similar methods with less-concentrated portfolios have been seeing similar outperformance over broad market passive indexes lately.

And McRedmond says he's seen the same general trend with ETFs sponsored by PowerShares using Intellidex benchmarks developed by the American Stock Exchange. The quantitatively driven indexes have far greater turnover than traditional market-cap weighted indexes and use different fundamental factors to over-weight and under-weight sectors and stocks. The stated objective is to beat the market.

Still, a notable laggard exists. That's the third new 'legally' active ETF, the PowerShares Active AlphaQ (NYSE: PQY). Its portfolio is also run by AER Advisors and uses a quantitatively based system to select 50 of the most attractive names from the Nasdaq 100 index.

In the past three months, PQY has dropped 10.6% through Aug. 1. By contrast, the passive PowerShares QQQ (Nasdaq: QQQQ) was down 7.84% in that period.

"We're still searching for the right mix with that portfolio," said AER's O'Leary. "So we're turning over the maximum of three stocks per week because we're getting a lot of blow-ups. For example, recently we eliminated eBay."

That has been a plus, since eBay's down more than 25% this year. But the fund also has passed on QQQ's top holding, Apple (AAPL). "It doesn't pass our screens because its PE (price-earnings ratio) is too high," O'Leary said.

Whether he can turnaround its fortunes quickly or not, some observers say they remain unconvinced that active ETFs of any sort will prove to be long-term winners.

"Active managers on average can't outperform in the mutual fund world over time, and that's likely to turn out to be the same case with ETFs," said Michael Krause, president of AltaVista Research. "Three months isn't really enough time to tell anyone much at all."