Over the last several months, a number of actively-managed ETFs have been launched. These investment vehicles are essentially a hybrid of traditional mutual funds and ETFs, providing many of the benefits that have boosted the ETF industry (lower fees, greater transparency and flexibility, etc.), while implementing an active trading strategy in an attempt to outperform a market benchmark. While truly actively-managed ETFs (i.e., funds that permit managers discretion in trading) are a relatively new innovation, actively-managed ETFs have technically been around for some time, pioneered by PowerShares, which launched several funds in 2008.
Not Quite Active, Not Quite Passive
PowerShares’ actively-managed ETFs are unlike traditional ETFs in that they do not attempt to track any type of benchmark. Rather, the composition of these funds is generally determined by a two-step process:
- Eligible stocks are determined by certain quantitative requirements, such as size (e.g., stocks with a market capitalization of more than $400 million are eligible for inclusion in PQZ). These restrictions effectively limit the potential universe of investments to correspond to popular benchmark indices.
- A proprietary stock-screening methodology is implemented to select individual equities.
But these funds are also quite different from traditional actively-managed ETFs with regards to the amount of discretion afforded to managers. Given the strict (i.e., daily) disclosure requirements of ETFs, there exists the potential for traders to engage in “front-running,” or moving into stocks they believe an ETF is in the process of buying and moving out of stocks the ETF is in the process of selling. Although it’s difficult to determine just how effective these strategies are, this “disclosure dilemma” is often cited as a primary reason for the lack of actively-managed ETFs on the market today.
Unlike most actively-managed portfolios that trade based primarily on manager discretion, PowerShares implements a quantitative methodology, utilizing proprietary models to select stocks it believes will outperform. As such, these funds aren’t fully active either. Initially, PowerShares also placed restrictions on when and how frequently its funds could trade, although these restrictions have since been removed.
Many of the PowerShares active ETFs have been around for more than a year, providing an ample period over which their performance can be evaluated. Here’s a quick overview of performance relative to stated benchmarks:
- Active Alpha Multi-Cap Fund (PQZ): This ETF, which includes approximately 50 stocks, is comprised of the top-rated equities as indicated by PowerShares’ proprietary methodologies. The universe of stocks that are eligible for this fund roughly corresponds to the Russell 3000 Index, which is tracked by several ETFs, including IWV. For the year ended May 31, PQZ was down approximately 45%, compared to a drop of only 34% for IWV.
- Active Mega-Cap Fund (PMA): This fund’s universe includes the Russell Top 200 Index, as well as certain other mega-cap equities. PMA (down 28%) has outperformed the Russell Top 200 Index (down 33%) over the past year. (There are no ETFs tracking the Russell Top 200 Index – XLG, which tracks the Russell Top 50 Index, is the closest)
- Active Low Duration Fund (PLK): This ETF invests at least 80% of its total assets in a portfolio of U.S. government, corporate, and agency debt securities while maintaining an average duration of less than three years. Although PLK invests in some corporate and agency securities, PowerShares’ web site indicates it is benchmarked against the Barclays Capital 1-3 Year U.S. Treasury Index, which is tracked by SHY. Over the past year, PLK, while exhibiting greater volatility, has essentially matched the return of this benchmark.
Although the sample size of ETFs considered in this analysis is admittedly small, the results nonetheless reinforce the case for passive indexing. Of the three funds considered, one underperformed relative to its benchmark, one overperformed, and one equaled its benchmark. Since numerous studies have proven that most managers are unable to consistently beat the market, this is what we would expect from a random sample: half of active funds come out above the benchmark, and half below. Assuming that this averages out to equal the benchmark, the differences in fees between an active and passive strategy (which in many cases exceeds 1% annually) is the primary determinant of relative performance. When it comes to expense ratios, mutual funds are no match for ETFs, with the average mutual fund expense ratio in the neighborhood of 1.4%, compared to ETF expense ratios as low as 0.10%.