An Active ETF Gets Its Wings

by on March 16, 2010 | ETFs Mentioned:

The monthly data release of ETF trading data from the National Stock Exchange always provides a comprehensive industry snapshot, detailing fund flows, asset levels, and the latest update on an increasingly-competitive battle for market share. There is no shortage of number-crunching following each release, but most of the analysis focuses on high level industry trends, such as month-over-month growth, cash inflows, and success of recent high-profile launches.

A look beyond the handful of mega-tickers that account for the majority of assets often reveals some interesting trends. Buried in the February release (in line number 699 to be exact) were some interesting stats that may signal an exciting new era for actively-managed ETFs. One of the handful of active ETFs available to U.S. investors saw assets surge last month, and has been enjoying a jump in trading volumes ever since. The PowerShares Active AlphaQ Fund (PQY) saw cash inflows of $14 million in February, increasing total assets under management by more than 400% from the previous month.

Inside PQY

PQY was launched in April 2008, one of the “first generation” of active ETFs introduced by PowerShares (along with PQZ, PMA, PLK, and PSR, this ETF makes portfolio decisions based on proprietary quantitative models, but doesn’t allow manager discretion in selecting individual stocks). For nearly two years, PQY has struggled to gain traction, a symptom afflicting other active ETFs as well (at the end of January, the five active PowerShares ETFs had just $30 million in assets).

PQY’s methodology is a standard quantitative approach; the fund rates U.S.-traded stocks of companies with market capitalizations of $400 million or more on a weekly basis. The fund’s sub-adviser then generates a “master stock list” that ranks these stocks, segmented by market cap, based on its proprietary stock-ranking methodology. Stocks are selected based on factors such as strong earnings growth, low valuations and positive money flow. From a universe defined as the 100 largest Nasdaq-listed securities, fund managers select and purchase approximately 50 stocks.

PQY’s performance hasn’t been overly impressive. The fund’s fact sheet describes PQY as an “actively-managed ETF that seeks to outperform the benchmark NASDAQ-100 Index.” Since May 2008, PQY’s cumulative return has lagged QQQQ, a passively-managed ETF linked to the NASDAQ-100, by about 800 basis points. Since the calendar turned to 2010, however, PQY has been on a tear, outpacing QQQQ by about 120 basis points.

PQY Has Delivered Returns Between the Nasdaq and S&P 500 Since Inception

Of PQY’s 50 holdings, about 38 are also found in QQQQ, although the individual weightings often vary significantly. GOOG, for example, accounts for about 4.7% of QQQQ but just 1.7% of PQY. Apple, which is QQQQ’s largest holding at nearly 16% of assets, isn’t included in PQY. This absence makes PQY’s 2010 performance even more impressive, as AAPL is up nearly 6% on the year.

Momentum Building?

PQY’s success has seemingly continued into March; according to the fund web site assets are now just south of $21 million. Daily trading volumes now regularly top 10,000; prior to February the median daily volume since inception was just 800 shares.

But any declaration of an active asset boom may be premature; of the nine other equity ETFs tagged as “active” in our ETF screener, only PQY saw cash inflows in February. Active ETFs have been hailed as a gamechanger in the investing arena, but momentum has been slow to materialize. In addition to the five ETFs offered by PowerShares, Grail Advisors maintains a line of actively-managed stock and bond ETFs.

Last year, bond fund giant PIMCO launched its first actively-managed funds, and has subsequently added two more (PIMCO also offers five bond index funds). PIMCO’s entrance into the space gave active bond ETFs a boost (MINT now has more than $170 million in assets), but investors have so far been hesitant to make the switch to active equity funds. Among the obstacles these funds face are limited track records, lingering concerns about the impact of ETF disclosure requirements, and relatively lofty expense ratios.

PQY’s recent surge doesn’t mean that active ETFs have arrived or that a bursting of the floodgates is imminent. But it does clearly show that there investors out there who believe a marriage of active management and the ETF structure can be very valuable. Coming months will tell whether the momentum is sustainable.

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Disclaimer: No positions at time of writing.