Special Report: Alpha ETFs Come Of Age

by on September 1, 2009 | ETFs Mentioned:

In the summer of 1992, Eugene Fama and Kenneth French published “The Cross-Section of Expected Stock Returns” in The Journal of Finance, a groundbreaking analysis that prompted financial presses to run headlines declaring “beta is dead.” While the death sentence may have been a bit severe, it struck a significant blow to a widely-accepted and longstanding financial concept, causing academics and investors to reconsider tenets they once took for granted.

In recent decades, a collection of academic studies, disillusioned investors, and financial innovations have contributed to a similar prognosis for beta’s Greek neighbor, alpha. The idea that was hatched by Brinson and Hood and supported by the likes of Ibbotson and Kaplan and Barras and Scaillet was fueled by years of investor frustration. Following the introduction and rapid rise in the popularity of indexing and ETFs, it seemed that what started out as a scholarly whisper had grown into a deafening roar. The proclamation didn’t come from a single voice or article, but was the collective result of years of research and investor sentiment that has seemingly led to a fatal promulgation: alpha is dead.

Or is it?

ETFs and Alpha Aren't As Incompatible As You Might ThinkMany investors point to the rise in popularity of indexed mutual funds and ETFs as clear evidence that investors have abandoned their search for excess returns, preferring the designation of “beta grazer” over “alpha hunter.” Disillusioned by the failure of actively-managed investments to consistently outperform their benchmarks, and cognizant of what Jack Bogle calls “the tyranny of compounded returns,” many investors have abandoned pricey mutual funds that seek to beat a benchmark in favor of low-cost funds that simply seek to match the return of their underlying index.

But there’s a lot more to the ETF industry than meets the eye.

While the vast majority of ETF assets are invested in “traditional” beta funds that track widely-followed equity and fixed income benchmarks (such as the S&P 500 and the MSCI Emerging Markets Index), there are a number of funds that track non-traditional “intelligent” indexes. These benchmarks are typically constructed using various proprietary quantitative methodologies designed to isolate individual equities poised to outpace the broader markets and experience above-average capital appreciation.

So the notion that the birth and meteoric rise of ETFs signaled the death (or at least a steep decline) of active, alpha-seeking investing isn’t quite accurate. And while the size of the “alpha” ETF market currently pales in comparison to that of traditional passively-managed funds, there are reasons to believe that intelligent and active ETFs will experience massive growth in coming years.

Ancestors Of Active ETFs

The “inception” of the actively-managed ETF has received a great deal of media attention this year (including multiple articles on ETF Database) with the introduction of Grail Advisors’ Beacon Large Cap Value Fund (GVT). But the history of the actively-managed ETF began well before June 2009. True, GVT is the first ETF to allow manager discretion in the selection of individual holdings. But a primary talent of active managers, whether it be an individual investor, a mutual fund provider, or an ETF manager, is quantitative analysis. With GVT (and likely with future active ETFs as well), a human being may make the ultimate buy and sell decisions, but I’d be willing to bet that there is a fair amount of quantitative analysis going on behind the scenes. There are dozens of ETFs whose holdings (as well as the weighting afforded to each holding) are determined by various degrees of quantitative analysis. These ETFs have effectively been employing active management techniques for years before GVT was launched.

Alpha: Alive And Well In Chicago

Just as reports of beta’s “death” were premature (the concept is still widely taught at universities and used by financial professionals in rate of return calculations), reports of alpha’s demise may have been a bit early. In the suburbs of Chicago, alpha isn’t dead – it’s alive and well. And its marriage to the ETF structure, although still in its early years, has been a happy one. If you take a short drive west of downtown Chicago, you’ll come across a hotbed of alpha ETF activity. Visits to three ETF issuers in the area – InvescoPowerShares, First Trust, and Claymore – shed some light on the misconception that active management is a thing of the past.

The “Intelligent ETF Revolution” At PowerShares

PowerShares’ largest and best known ETF, in terms of asset size and widespread use among investors, is without a doubt the QQQ Trust (QQQQ). But there’s a lot more to the Wheaton, Illinois-based firm than the Qubes. The company’s “Dynamic” ETFs, and the “Intellidex” benchmarks upon which they are based, present a particularly compelling case for the benefits of active management.

PowerShares takes a unique approach to the methodology of the indexes underlying many of its ETFs. Traditional indexes determine their holdings based largely on market capitalizations, but many investors now understand that there are inherent limitations and drawbacks cap-weighted allocations. Most equity indexes were never designed to serve as investment vehicles, but rather as broad market barometers and benchmarks against which managers would be measured.

The benefits of the exchange-traded structure can be harnessed through various fund types, a point PowerShares took to heart in the development of its ETF product line. “The ETF is a great delivery vehicle that wasn’t being fully utilized by the first generation of exchange-traded funds,” says Ed McRedmond, Senior Vice President of Portfolio Strategies at Invesco PowerShares. “For those investors who believe in active management, why wouldn’t they want it delivered through an efficient investment vehicle?”

PowerShares believes its line of Intellidex-based funds deliver benefits of tested and proven stock selection methodologies with the cost and tax efficiencies that come with the ETF structure. The Intellidexes utilize a proprietary multi-factor model to determine holdings. By considering a number of investment criteria, including fundamental growth, stock valuation, investment timeliness, and risk factors, all potential holdings are evaluated from multiple perspectives. And by evaluating potential holdings using metrics that have been linked to superior performance, the Intellidexes hope to improve the likelihood of outperforming broad-based market capitalization-weighted indexes.

The exact inputs considered and algorithms employed to determine the composition of the Intellidexes are obviously proprietary (and wouldn’t be of much interest to many of us anyways). What is readily available (and significantly more interesting) is an abundance of evidence supporting the effectiveness of the Intellidex strategy at identifying winners.

ETF/Index Inception Annual Performance Since  Inception
Dynamic Basic Materials Intellidex (PYZ) 10/12/2006 -4.4%
S&P Materials Index n/a -5.9%
Dynamic Financials Intellidex (PFI) 10/12/2006 -16.1%
S&P 500 Financials n/a -29.9%
Dynamic Industrials Intellidex (PRN) 10/12/2006 -8.9%
S&P Industrials n/a -13.5%
Dynamic Banking Intellidex (PJB) 10/12/2006 -22.5%
Dow Jones U.S. Banks Index n/a -33.4%
Dynamic Software Intellidex (PSJ) 6/23/2005 3.2%
S&P Software n/a -1.0%

The fact that many of the returns displayed above are negative is, of course, primarily related to the timing of the performance. But as many investors can now attest, ability to minimize losses and preserve capital during a recession is just as important as the ability to generate positive returns during bull markets. There are, of course, examples of Intellidexes that have lagged similar S&P benchmarks since their exception as well. But the fact remains that PowerShares “intelligent” indexes have proven themselves capable of delivering excess returns.

“AlphaDEX-ing”

AlphaDEX SystemJust down the road from PowerShares is First Trust, a dominant player in the UIT and variable annuity industry that has boldly forged into the ETF space with its own line of “enhanced” index-based ETFs. First Trust utilizes a proprietary, rules-based stock selection methodology known as “AlphaDEX” to construct indexes it believes are positioned to outperform traditional benchmarks. As displayed in the adjacent table, the First Trust methodology applies the AlphaDEX ranking system to broad-based indexes in order to separate the good stocks from the bad.

But the AlphaDEX system doesn’t stop there. Instead of employing a traditional market capitalization weighting methodology, these enhanced benchmarks determine allocations to individual holdings based on measures such as price-to-book, price-to-cash flow, price-to-sales, and return on assets. The rationale is that these metrics are much more important indicators of performance than market capitalization, and that the application of an alternative weighting methodology offers another opportunity to outperform the benchmark.

Again, the proof is in the pudding. And for the AlphaDEX ETFs, the evidence is quite compelling. Through the second quarter of 2009, the Defined Large, Mid, and Small Cap Core Indexes had significantly outperformed the broad-based indexed from which they select their holdings.

Index (ETF) YTD Performance
Defined Large Cap Core Index (FEX) 7.9%
S&P 500 3.1%
Defined Mid Cap Core Index (FNX) 15.2%
S&P MidCap 400 8.5%
Defined Small Cap Core Index (FYX) 20.5%
S&P SmallCap 600 11.1%

Alpha/Beta Hybrid

Claymore, yet another Chicago-based ETF issuer, boasts a long list of ETF industry firsts, including the first BRIC and Frontier Markets ETFs (EEB and FRN, respectively) and the first ETF offering exposure to the solar power energy (TAN). Although the benchmarks underlying many of Claymore’s ETFs are unique, their construction methodologies are more traditional.

But not all. Claymore offers a number of funds that attempt to generate alpha by tracking enhanced benchmarks. A few such funds:

  • Claymore/Raymond James SB-1 Equity ETF (RYJ): Tracks an index comprised of all equity securities rated “Strong Buy 1″ by Raymond James & Associates.
  • Claymore/Zacks Sector Rotation ETF (XRO): Tracks an index comprised of about 100 stocks selected based on certain investment criteria from a universe of the largest 1,000 companies by market capitalization.
  • Claymore/Zacks Country Rotation ETF (CRO): Tracks an index comprised of about 200 stocks selected based on certain investment criteria from a universe of companies based in countries included in the MSCI EAFE Index (including Canada and excluding Greece).

Perhaps Claymore’s most interesting ETFs are the Claymore/Ocean Tomo Patent ETF (OTP) and the Claymore/Ocean Tomo Growth Index ETF (OTR). “The investment thesis behind these products is that intellectual property is a significant driver of a company’s valuation,” explained Claymore President Christian Magoon in an interview with ETF Database last week. “These funds look for companies that are relatively inexpensive based on the ratio of the value of their patents to book value.”

And again, we find proof of life when we look at the data. “Since inception, the broad based patent index has achieved about 400 basis points better performance over the S&P 500 and the more narrow growth index has achieved about 100 basis points better performance than the Russell 1000 Growth Index,” notes Magoon.

Not Dead, Just Evolving

There’s little debate that active management as we once knew it has taken a body blow, delivered by a daunting tag team of frustrated investors and dynamic ETF innovation. But the combination of active management techniques within the ETF structure has, in many cases, proven to be a value-added partnership that more and more investors are embracing. “Alpha” ETFs are one of the many innovations to the ETF industry that have resulted in a significant expansion of the ETF product line beyond “plain vanilla” funds that passively track well-known benchmarks (see our Free Guide to ETFs for Very High Net Worth Investors for a complete rundown).

The financial press is chock full of predictions of how and when ETFs will replace mutual funds. As a staunch believer in the benefits of ETFs relative to mutual funds, I can tell you with near certainty that such a scenario will never play out. Active management will always have its supporters, as will  indexing. What is more likely is a gradual blurring of the lines between the two alternatives that once seemed to be diametrically opposed. The introduction and proliferation of various “intelligent” and “enhanced” indexing strategies were perhaps the first step in this process; the introduction of the “Grail Fund” is no doubt another milestone.

As the ETF industry continues to evolve, the future of the battle between indexing and active management styles remains murky. But one thing is certain: we haven’t seen the last of alpha.

Disclosure: No positions at time of writing.