Exchange-traded funds (ETFs) came into this world as passive vehicles, designed to offer low-cost and tax-efficient exposure to indices. Their raison d'être was beta, pure and simple.
But, things became complicated. Competition in the ETF space long ago consumed all the licensing opportunities for the well-established indices developed by Standard & Poor's, Dow Jones and Russell. Now it's a world of "self-indexing" as ETF sponsors manufacture novel (and cheaper) exposures of their own.
The trend has been fueled by a growing interest in "smart beta," "strategic beta," "fundamental indexing" or whatever verbal construction that bespeaks using something other than a cap-weighted vanilla index. The cascade of factor-based investment strategies in ETF wrappers - now up to nearly 800 such products, according to the ETF.com website - began with the launch of the first fundamental index ETF in 2005.
Most recently, the popularity - and some would say, utility - of beta is being eclipsed. You can see that (Chart 1) reflected in a stair-step decline in the CBOE S&P 500 Implied Correlation Index (CBOE: KCJ). The index is derived by comparing the cost of S&P 500 index options to the prices of options on the benchmark's largest component stocks and declines as market expectations of correlation within the index weakens. In other words, the index falls as beta plays cede ground to alpha-seeking adventures.
So, the ETF business is getting adventurous, going beyond beta to include a whole new category of alpha-seeking ETFs. According to ETF.com, these alpha-seeking ETFs are "equity funds attempting to outperform the market with various investment strategies" - a rather nebulous and seemingly inclusive characterization at best. A total of 78 products are installed in this category, with just a half dozen (8 percent) awarded the website's top grades ("A" or "B").
Earning Top Grades
So, what makes these funds so special? How did they fare in 2016, and at what cost did they pursue alpha?
Five of the top-rated funds draw their components from the broad market - that is, from all capitalization tiers - and one exclusively uses the large-cap stocks found in the S&P 500.
Topping the list, and earning the only "A" rating, is the VanEck Vectors Morningstar Wide Moat ETF (NYSEARCA:MOAT), an equal-weighted portfolio of 20 companies deemed to have sustainable advantages over their competitors. These "wide moats" may include category-defining brand names, high barriers to entry or some costly impediments to product switching.
MOAT's small array of stocks naturally lends concentration risk and leads to some decidedly "unmarket-like" behavior. The fund's .64 r-squared (r2) coefficient versus the Vanguard Total Stock Market ETF (NYSEARCA:VTI) implies that only about two-thirds of its price trajectory last year can be explained by the broad market. The other all-cap ETFs posted a .91 average r2 for 2016.
MOAT clearly outdid the broad market last year, albeit with incrementally higher volatility. The fund earned a big alpha, meaning its 8.74 percent outperformance of a beta-adjusted VTI was truly idiosyncratic. It, however, doesn't consistently surpass the broad market. Over the past three years, the fund earned a mildly negative (-.34 percent) annualized alpha.
The next three alpha seekers represent a suite of Northern Trust portfolios built around a quality theme. The FlexShares Quality Dividend Index ETF (NYSEARCA:QDF) aims for relatively high, but sustainable, dividends by scouring its universe for profitable and efficiently managed companies with good cash flows.
When you think of the FlexShares Quality Dividend Defensive Index ETF (NYSEARCA:QDEF), think of QDF with a beta filter. Using the same universe as QDF, QDEF draws in the lower-volatility issues. Over the long run, putting a governor on a fund's beta tends to preserve hard-won gains. That's why the QDEF fund did better than all of its peers over the past three years, earning an 8.96 percent annualized alpha.
At the opposite end of the volatility spectrum is QDEF's sibling, the FlexShares Quality Dividend Dynamic Index ETF (NYSEARCA:QDYN), which pulls in the higher-beta components from the quality stock space. Volatility has its price, though. Despite QDYN's performance in 2016, the fund posted negative alpha over the most recent three-year period.
The last all-cap fund on our list, the Direxion All Cap Insider Sentiment ETF (NYSEARCA:KNOW), a portfolio that relies on the trading action of company officers and directors for value clues. Still, that's not the only criterion. The fund's 100 stocks are also qualitatively screened for earnings quality, growth trends and valuations. Despite underperforming the broad market in 2016, KNOW netted the best annual growth rate (13.98 percent) over the past three years.
Rounding out the "B" tier is a large-cap portfolio that maintains a constant hedge exposure. The PowerShares S&P 500 Downside Hedged Portfolio ETF (NYSEARCA:PHDG) actively allocates its portfolio across S&P 500 stocks, VIX futures and cash in an attempt to snag uncorrelated positive returns. The portfolio is analyzed daily for needed adjustments; as market volatility declines, VIX futures exposure is reduced, while the equity allocation expands. The process reverses when volatility spikes higher.
The expense of maintaining a hedge posture is reflected in PHDG's return. Last year was a loss for the fund, though its methodology shaved a quarter off the market's volatility. Unfortunately, this is a persistent theme. It was the only fund in our list to post negative annual growth over the past three years.
Positive alpha is elusive; beta is ubiquitous. Beta can be cheaply sourced through many ETFs, including the most popular all-cap index tracker, VTI, which costs just 5 basis points (.05 percent) to hold. You'll get no alpha from VTI, just beta.
MOAT, at 49 basis points, bestows both beta and alpha, so to say you're paying 49 basis points for the fund's alpha just isn't accurate. Part of that expense gets you the cheap market exposure, and the rest finances the idiosyncratic return.
The key to finding the true cost of the active return, according to risk consultant and former SUNY finance professor Ross Miller, is that r-squared (r2) coefficient, which reveals how much of a fund's price trajectory is explained by the market. The coefficient provides a basis for dividing a fund's behavior into active and passive buckets.
Using MOAT's r2, Miller's math determines an active weight of 43 percent. Then, by concentrating the fund's fee premium, i.e., the cost in excess of pure beta, on the active portion, a true cost of 107 basis points for MOAT's stock selection can be derived. Is that an exorbitant fee? Not necessarily. If we push the fund's alpha through Miller's sieve to assign a value to the active portion of the portfolio, a coefficient of 20.36 emerges, representing a 19-fold payback for the active expense.
Over three years, though, MOAT doesn't fare so well. In fact, the payback ratio is mildly negative for the insider sentiment fund. Over the longer term, the real alpha dog is the low-volatility QDEF, which earns a seven-fold payback for its active expense, handily outdoing the rest of the table.
That said, is low-vol the pathway to cost-efficient alpha? Clearly, the performance of the PHDG fund is evidence that low volatility, by itself, is not the route. Something more is needed. Over the past three years, coupling quality - efficient management, low valuations and strong cash flows - with low beta seems to be a better formula.