Active ETFs are ripe for transparent, low-cost strategies

They combine the benefits of active management with liquidity, transparency and cost efficiency

Aug 22, 2017 @ 3:31 pm

By Vinay Nadkarni

Over the last decade, active U.S. large cap strategies with lower turnover and greater concentration have delivered solid performance, better down-market capture and higher Sharpe ratios than more diversified, higher turnover active strategies.* This can make them especially appealing in an exchange-traded fund (ETF) wrapper: the potential benefits of active management, with the benefits of liquidity, transparency and cost efficiency.

Do we need more active management? The better question is, what kind of active management should investors consider? Active ETFs focused on fundamentals can be a great complement to client portfolios.

Active management offers opportunities not available through passive strategies. Managers can find mispriced stocks in less efficient parts of their markets by properly valuing the individual earnings potential, benefits and risks of businesses, and building them into a strategic portfolio.

The focus can be on risk as well: fundamental security analysis can eliminate individual stocks or entire sectors that are overvalued or may otherwise be poised for a correction. They can also monitor existing position sizes and adjust as market, industry and company-specific conditions change.

Active managers essentially seek to manage the risk of stocks. They thoroughly model the worst possible outcomes for a stock, wait for the entry point that appears to offer attractive potential returns for a given level of risk, then adjust the percentage of holdings based on their relationship to the overall risk characteristics of the portfolio. Dynamic risk management capabilities like these are not available in market-cap-weighted passive strategies.

The reality is that investors have embraced the ETF vehicle; regulators are heavily focused on ensuring that fees paid by retail investors meet "fiduciary standards" (for retirement accounts); thus the continued popularity of active ETFs appears inevitable.

Investors have accepted the rationale of buying ETFs – as proven by their large inflows of money. According to Simfund, in the first quarter of 2017, ETF inflows hit an all-time high of $125 billion. This may be due to 2016 being a generally poor year for many actively managed funds.

ETFs became popular because of their liquidity, tax efficiency and lower costs. For passive ETFs designed to mimic the performance of an index, costs can be attractively low.

In the current bull market, many passive ETFs also have outperformed many actively-managed mutual funds, particularly in U.S. large-cap and mid-cap equities. But if volatility returns to the market, the tide may turn back to active management, and investors may want active products that use the ETF vehicle.

With the U.S. equity markets having climbed to historical heights, riding the major indexes with low-cost passive ETFs proved a successful strategy. When markets do little more than go up – and up and up – it is easy to enjoy the ride, and make money. In recent years, investors have not had to deal with significant corrections, sustained periods of high volatility or other shocks.

Yet U.S. equity markets do not always rise. When they don't, lower turnover strategies can be a compelling option. Large-cap portfolios with lower turnover outperformed portfolios with higher turnover during down markets in each of the rolling five-year periods that encompassed the last two bear markets.*

Investing in passive indexed products means that when markets turn and start to go down, these ETFs will dutifully follow them. No one is there to manage risks, which can be exacerbated by the sheer number of people invested in index strategies. Hanging onto a falling index in a volatile market could become a very bad idea.

Large-scale, index-tracking ETFs can bring risk of undue market concentration, caused by methodologies that buy proportionally more of some stocks than others, making larger bets on popular names and sectors. Investors in passive indexed products may be unaware of their exposure to these concentrated risks. We believe active ETFs can be an option to help mitigate those risks.

It should come as no surprise that 60% of ETF sponsors are either currently developing or planning to develop active ETFs, according to Cerulli. Advisers would do well to inform clients that the term "ETF" is not necessarily synonymous with "passive."

*Source: eVestment. Performance information does not include the effects of fees or sales charges.

Vinay Nadkarni is managing director, head of portfolio specialists at ClearBridge Investments.

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