This article originally appeared in the January issue of REP./WealthManagement Magazine and online at WealthManagement.com
Headline numbers will not tell you what you need to know.
In 2015, exchange traded funds (ETFs) celebrated a 25-year anniversary by commemorating the 1990 launch of the Toronto 35 Index Participation Units.
Thousands of ETFs have since been introduced-and many subsequently retired. Lost among the multitude of index trackers, however, are a handful of late-entry actively managed products.
It's fair to ask how good these active ETFs are as alpha producers, but finding the right answer isn't easy. First, there's the novelty of the product line. Few active ETFs have the three-year track record required by outfits like Morningstar for detailed analysis. And then there's the problem with the analysis itself.
Morningstar assigns a so-called "standard index," such as the S&P 500 Index or the Barclays Capital U.S. Aggregate Bond Index, as a benchmark for each ETF. This index, in Morningstar's own words "has the highest correlation to the funds in the asset class based on at least three years' worth of return history."
That's rather hard to believe if you look at the numbers.
Take the case of the PowerShares Active U.S. Real Estate ETF (NYSE:PSR) as an example. Why would Morningstar think the MSCI All Country World Index is a suitable benchmark for PSR when the fund's r-squared coefficient is only 15.01 against the global equity index? After all, the fund's "best-fit" index, the S&P U.S. REIT Index, explains nearly 99 percent of PSR's movements.
Here's the rub: If you go into a search for ETFs with the highest alpha, the output is most likely to be based on Morningstar's standard index, not the best-fit one. That could lead you to attribute unwarranted skill (or ineptitude) to a fund manager. Case in point: PSR sits at the top of the alpha search list with a 6.49 coefficient against the MSCI ACWI benchmark. The fund, however, earns a -0.10 alpha versus the S&P U.S. REIT Index. Yes, PSR indeed earns alpha. The problem is, against a real benchmark for its asset class, it's negative alpha.
Seeing this, we decided to test the top 10 alpha crankers in the Morningstar active ETF universe. To better simulate real-world conditions, we relied on daily, not monthly, returns for the past three years. This gives us hundreds of data points to study rather than the dozens used by Morningstar. Daily data yields more granularity, so the resultant coefficients can differ widely from those derived monthly. We think the larger data field produces metrics that are more predictive of day-to-day performance.
Then we searched for investable benchmarks, namely passively managed ETFs that comported best with the subject funds' prospectus benchmark, or lacking that, an ETF tracking the Morningstar best-fit index. In our study, for example, PSR's yardstick was the First Trust S&P REIT Index ETF (NYSEARCA:FRI), a passive fund tracking the S&P U.S. REIT Index. The rationale here is simple: if the active ETF doesn't really provide better results than a passive product, wouldn't an investor use the most appropriate (and lower-cost) index fund to fill the desired allocation bucket?
Chart 1 puts the foregoing into perspective. For PSR, the monthly r-squared coefficient against FRI is 93.48; measured daily, it's 73.60. The iShares MSCI ACWI Index ETF (NASDAQ:ACWI) tracks Morningstar's standard index with a monthly r-squared fit at 10.89 and a daily coefficient at 24.64.
Top 10 Alpha Producers
Morningstar's top alpha-producing active ETFs cover a wide swath of asset classes including large-cap equities, clean energy companies, ultrashort-term debt and ADRs (American Depositary Receipts). The alpha spectrum is broad, too, with the topmost ETF generating a nominal alpha coefficient 100 times higher than the table's laggard.
Leading the pack with a 12.33 alpha reading is the Columbia Select Large Cap Growth ETF (NYSEARCA:RWG), a fund that uses fundamental and quantitative analysis to find companies with above-average growth prospects. The fund's self-avowed universe is the Russell 1000 Growth Index, making its benchmark ETF the iShares Russell 1000 Growth ETF (NYSEARCA:IWF). Morningstar's standard index for this fund is the S&P 500, so the alternative ETF is the SPDR S&P 500 Trust ETF (NYSEARCA:SPY).
In the cellar is the AdvisorShares EquityPro ETF (NYSEARCA:EPRO), a fund of funds focused on global tactical asset and sector allocation. The fund's equity exposure is timed according to U.S. stock market momentum and the shape of the domestic yield curve. In its defensive mode, the fund's equity exposure could be as little as 20 percent of net assets with the remainder held in cash or fixed income securities. This, obviously, can create a lot of volatility in the portfolio.
Morningstar assigns the MSCI All-Country World Index Ex-U.S. as EPRO's standard index and deems the Morningstar Lifetime Moderate 2030 Index its best-fit index. Finding a passive ETF benchmark for this fund has been complicated by recent closures of target-date products. The closest asset allocation fund extant is the iShares Core Moderate Allocation ETF (NYSEARCA:AOM). Against AOM, EPRO earns a barely perceptible 0.12 alpha coefficient.
The fund with the tightest correlation to its benchmark ETF is the AdvisorShares TrimTabs Float Shrink ETF (NYSEARCA:TTFS), which attempts to outdo the Russell 3000 Index. TTFS managers cull the Russell universe for companies that are buying back shares, boosting free cash flow and reducing corporate leverage. Morningstar's standard index for this fund is the S&P 500, while its best-fit index is the Russell 3000, making its directly comparable ETF benchmark the iShares Russell 3000 ETF (NYSEARCA:IWV).
So what's the takeaway from all this? Just this: Alpha's hard to come by. It should be. That's why we're willing to pay up a little for it. Alpha derived from standard indices, however, is, well, generous. Go back to the PSR fund for a moment. As you can see from Table 1, its alpha against the First Trust FRI portfolio, the best-fit tracker, is 2.35. Against the equally investable iShares ACWI, a proxy for the fund's standard index, there's a 6.83 coefficient. Which metric better illustrates the portfolio runner's skills as a real estate investment manager? Using the standard index proxy, you can't tell how much of the alpha is actually real estate beta.
Now, that got us thinking. Why don't we drill down further to find just how much active management there was inside these ETFs? What portion of each fund's portfolio was given over to idiosyncratic investment and how much to the benchmark? In other words, what part of the portfolio actually delivers alpha and what part beta? Beta, of course, is the raison d'être for index ETFs.
Active, Active, Active
The mathematics for determining the active weights of a fund can be found in a 2007 working paper, "Measuring the True Cost of Active Management by Mutual Funds" by SUNY at Albany economics professor Ross Miller.
By Miller's reckoning, about 58 percent of our average ETF portfolio's real estate is given over to active management; the remaining 41 percent tracks the benchmark ETF. At one extreme is the AdvisorShares TTFS fund, which devotes less than a third of its space to its distinctive investment protocol. The Guggenheim GSY's portfolio, on the other hand, is pretty much an entirely active creation.
Miller's math helps us derive the true cost for the active portion of the portfolios and, by extension, more representative alpha coefficients.
We know 41 percent of the ETF space in our universe is devoted to producing beta. The commercial value of market tracking in this universe, i.e., the average cost of the benchmark ETFs, is 26 basis points. The active funds, however, charge a mean expense of 86 basis points. If we concentrate the fee premium on just the actively managed portion of the portfolio, we come up with an actual cost of alpha production at 145 basis points.
And the alpha produced from the active share of the portfolios? On average, it's 959 basis points, an impressive number considering the 533 basis points average for overall alpha. The payback ratios in Table 2 represent the cost efficiency (active alpha divided by active expense) of each portfolio. As you can see, most of these portfolios provide rather handsome compensation for manager risk.
By any measure, these are plainly top-tier funds. There's a flotilla of actively managed ETFs, however, that are presently under Morningstar's radar: Only a tenth of the 140 products extant are rated by the firm. As time passes, more funds will earn their Morningstar metrics. When they do, it'll pay to dig for their alpha sources. The headline numbers may not tell you what you really need to know.