Keeping Tabs on Actively Managed ETFs and Alpha in the ETF Space

by: Street One Financial

By Paul Weisbruch

Recently, the ETP industry learned that BlackRock finally received exemptive relief to launch actively managed ETFs, namely the iShares Active Fixed Income Fund and the iShares Active Equity Fund. Perhaps this move by the largest ETF issuer in terms of assets will alter the general thought process among many industry participants including institutions, financial advisors, and RIAs that "ETFs are passive beta products." In addition to BlackRock's entrance into this segment of the ETF market, State Street is now in the active ETF space, and Russell Investments will soon be launching a suite of ETFs that are designed to deliver alpha for investors, as opposed to being pure "beta" plays like many of the ETF offerings currently available to investors. At Street One, we have noted an evolution in thought from 2008 to the present day where slowly but surely, the investment community is embracing the fact that the Exchange Traded Fund, or ETF is simply a wrapper, a means of delivering a product, and is not necessarily synonymous with "passive index" or "beta product."

The average investment advisor or retail ETF investor may have never heard of an actively managed ETF nor has considered that certain ETFs by design can deliver alpha to one's portfolio. In fact, according to Shishir Nigam's ActiveETFs In Focus, a website dedicated to the coverage of actively managed ETFs, there are 36 funds in this category currently. And to expand further on this budding space, a number of firms were pioneers in the actively managed ETF space including PowerShares, which launched PQZ. PQY, PLK, and PMA in April of 2008 and WisdomTree with their actively managed currency ETFs such as CYB, BZF, EU, and others. Another firm, AdvisorShares ETFs, actively partners with experienced money manager subadvisors who bring an actively managed strategy to the table and then the ETF sponsor delivers the strategy to the investment community within an ETF wrapper. DENT (AdvisorShares Dent Tactical) is one such example, as is GTAA (Cambria Global Tactical), HYLD (Peritus High Yield), GRV (Mars Hill Global Relative Value), AADR (WCM/BNY Mellon Focused Growth). Rounding out the active ETF front are also entrants including Grail Advisors, (which recently announced their purchase by Ameriprise Financial), PIMCO, and Russell Investments, all of whom will be joining this arena as well in the near term. In fact, looking at the planned Russell releases, funds with names such as "Growth At A Reasonable Price," "Aggressive Growth," "Consistent Growth," "Small And Midcap Defensive Beta," and "Low P/E" for instance, are in the works.

Interestingly, there is also a subcategory that we label as "quasi-active" or "quantitative," where the underlying strategy of these given ETFs is not designed to track a passive benchmark equity or fixed income index, but instead have some unique strategy designed to deliver alpha to a portfolio and potentially advance returns above and beyond some stated benchmark index such as the S&P 500 or the Russell 2000, for instance. ETF issuers that fall in this "quasi-active" space include First Trust ETFs with their AlphaDEX strategies such as FXH, FYX, FTA, FNX, and many others. AlphaDEX employs a quantitatively driven process where fundamental factors are examined, determining the composition of their indexes and individual equity weightings, with the goal being to provide some return over time that trumps a passive market capitalization weighted index such as the S&P 500 or the Russell 2000, for example. Similarly, RevenueShares (RWL, RWK, RWJ) employs a revenue weighting mechanism where existing indexes such as the S&P 500, S&P 400, and S&P 600 are individually ranked by companies' top line revenues and then rebalanced annually with the goal of generating higher returns over time compared to market cap benchmarks. RevenueShares also markets RWV (Navellier A-100) which is based on the portfolio manager Louis Navellier's proprietary stock rating system, where he grades equities based on fundamental and momentum factors, and then consequently owns the top 100 rated equities within the ETF. Justin Lowry of VTL Associates, subadvisor to the RevenueShares Funds, notes that "RWV rebalances on a quarterly basis. Because it is a growth fund, the turnover rate within the portfolio is typically pretty high. The 2010 year end rebalance produced an approximate 72% turnover of the portfolio."

PowerShares, as we mentioned, was a pioneer in the actively managed ETF space in 2008, and it also had a handful of quasi-active ETFs designed to deliver alpha to portfolios including the RAFI strategies such as PRF and PRFZ. Robert Arnott of Research Affiliates designed the RAFI methodology to screen equities by four fundamental factors: book value, cash flow, sales, and dividends and thus this leads to an underlying index that looks, and performs differently from an index ranked by market capitalization such as the S&P 500.

WisdomTree is fairly well known for its dividend and earnings based ETF strategies, such as DLN, DON, and EPS for example. Javelin Exchange Traded Shares markets JCO, based on the Dow Jones U.S. Contrarian Opportunities Index, which owns 125 equities and are screened much in the same fashion as a contrarian stock picker would, and instead of delivering benchmark returns, attempts to outperform via contrarian stock selection. We suppose that even Rydex, with their equal weighted strategies, such as RSP (S&P 500 Equal Weighted) should be considered quasi-active since the firm's modus operandi is to tweak an existing and embraced benchmark index such as the S&P 500 and deliver a higher total return by equally weighting that index and regularly rebalancing it. Also in the quasi-active space is IndexIQ, which is noted for its "Rules Based Alpha Investment" and offering of products such as MCRO (IQ Hedge Macro Tracker), MNA (IQ Merger Arbitrage), QAI (IQ Hedge Multi-Strategy), and CPI (IQ Real Return) for instance.

Why active, and why the push from ETF issuers to engage in the space? We asked Adam Patti, CEO of IndexIQ his thoughts and he said "As investors become more sophisticated in their use of ETFs, a logical migration of ETF strategies has begun. While ETFs had historically been focused on pure passive benchmarks like the S&P 500, now ETFs are gaining footholds in the more sophisticated, Alternative-Investing arena typically dominated by mutual funds and hedge funds. An excellent example of this is our IQ Hedge Macro Tracker ETF MCRO. MCRO is going on its two year anniversary and is the first and only Global Macro ETF.

Global Macro strategies are broad and diversified strategies that are generally "go anywhere, do anything" as they seek to exploit market and pricing inefficiencies. MCRO is a fully transparent index-based ETF that employs the use of 17 global asset classes across equities, fixed income, currencies and commodities - both long and short. MCRO dynamically rotates among those asset classes that are most desirable while shorting those asset classes that are least attractive. Investors use MCRO to generate alpha and non-correlated returns by carving out space from their equity and/or fixed income allocations. As an additionally benefit, MCRO has no K-1 and historically has never paid out capital gains."

Ron Heller, CEO and Senior Portfolio Manager at Peritus Asset Management, subadvisor of HYLD (AdvisorShares Peritus High Yield ETF) added in relation to the evolution of active ETFs that , "Size matters! In the active vs. passive debate size of the fund does matter. Peritus and HYLD is considered an emerging manager, even though Peritus has >10 year track record that is at or near the top of the charts as it pertains to performance. Peritus is able to consistently add alpha because we do not have >$8B under management and we can find 50 – 60 securities with return profiles that are well above our competitors. Many passive ETF's and separate account managers cannot buy these same securities due to liquidity and size constraints. Passive ETF's must mirror the Index's and contain hundreds and thousands of securities, essentially those portfolios must own every sector and others own every security depending on size and liquidity available. Peritus is able to make their own forecast of the future and build a portfolio around it where the competition is at the mercy of whatever the future holds in both the macro and micro sense.An example of this is PIMCO, look at their returns in the early days and look at what they produce now. Their returns were superior when they had $1B under management as compared to nearly $1T today"

Furthermore, Rodney Johnson, President of H.S. Dent, the subadvisor of DENT (AdvisorShares Dent Tactical ETF) points out, "ETFs are nothing but efficient mutual funds. They own underlying stocks or other investment securities. They are priced based on the value of what they hold. The difference is that ETFs give clients an added bonus – liquidity throughout the trading day. What is required for this liquidity is for market participants to know the holdings of ETFs on a daily basis, which is something that mutual funds have fought for years. Who can argue with greater transparency? Because ETFs are simply a more efficient form of a mutual fund, it stands to reason that they would evolve over time from index followers to vehicles that can, with one purchase, provide investors with access to alpha."

In reference to what the industry has noted in terms of growth in actively managed and simply ETFs that deliver alpha to portfolios, Noah Hamman, the CEO of AdvisorShares, a pioneer in the actively managed ETF space told us that "While much has been said about the growth of the actively managed ETF space, we put together an interesting comparison of the first three years of growth for active ETFs versus index ETFs' first three years of growth. There are a greater number of products and assets in the first three years of active ETFs compared to index ETFs. It is our opinion that the distribution is also very different for the first three years of each investment structure. It is reasonable to believe that most of the assets in the first years of index ETFs were primarily institutional investors, while we believe that the interest in active ETFs has been more financial professional-focused with a much broader number of investors adopting active ETFs in their investment strategies."

Critics will always be around as new and innovative ETF products are launched, and this is completely natural and expected. It is clear to us at Street One however, that the concept of ETFs designed to deliver alpha to one's portfolio and not simply serve as a passive beta product is becoming more mainstream, and will undoubtedly continue in this direction, especially as more ETF product sponsors foray into the space. We expect to see more ETF issuers enter this arena, and also foresee established traditional active managers whom currently offer only mutual funds attempt to capture the momentum at hand and become new entrants to the ETF world.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.