Does Your Firm Use Active ETFs?

July 01, 2018

ETF Report asked several advisors to weigh in on their reasons for usingor not using—actively managed ETFs.
 

We use active ETFs, specifically in the fixed-income space. On the equity side, we tend to stick to passive funds. However, our research has shown that active managers can outperform in more opaque areas of the market, such as preferred securities.

One reason we use active ETFs for fixed income is because these managers have the flexibility to maneuver around potential pitfalls that might befall passive funds.

For example, many passive fixed-income ETFs track a market-cap-weighted index. While market-cap weighting in equities means you own more of the larger companies in the index, in fixed income it means you own more of the companies that issue the most debt. Owning more of a company just because it issues more debt is not always a good thing. [Plus,] active ETF managers have some flexibility to alter their exposures, whereas passive ETFs are stuck to owning the index.

For preferred securities, we use the First Trust Preferred Securities & Income ETF (FPE). FPE does have a higher fee than its passive competitor, but it’s more than made up for it in performance. FPE’s active management has been especially beneficial in limiting downside volatility, as it owned more “fixed to floating rate” securities than the index. This has made it less sensitive to sharp interest rate movements.

For example, in Q4 2016, the yield on the 10-year Treasury jumped from 1.6% to 2.4%. The sharp rise in interest rates caused most fixed-rate instruments to decline in value. The iShares U.S. Preferred Stock ETF (PFF), the passive preferred ETF, [fell] 3.9% in Q4 2016. FPE, however, was only [down] 1.4%. FPE has outperformed PFF in each of the last one-, three- and five-year trailing periods.

 

The reason we don’t use actively managed ETFs has nothing to do with the fact that they’re ETFs and has everything to do with the fact that they’re actively managed. While we have relatively little performance history of actively managed ETFs, there are decades of available research on actively managed strategies (specifically, actively managed mutual funds). Those studies tell us it’s very difficult to outperform indices net of all expenses when engaged in active management.

As evidence-based investors, we look to the peer-reviewed research rather than Wall St. when it comes to developing our investment methodology. Until the research can demonstrate a way to reliably and sustainably keep up with the indices after cost, we’ll be avoiding active strategies within ETFs or otherwise.

 

Our portfolio manager, Mike Shell, doesn’t currently include active ETFs in our universe of tradeable ETFs, but that doesn’t mean he’d never include them. He tactically shifts between ETFs, based on investor behavioral measures and supply/demand. So our portfolio management style itself is the active management; we are, essentially, actively managing beta.

We use ETFs to gain specific exposure to a return stream such as a sector, country, commodity or currency. With an index ETF, we pretty much know what we’re going to get inside the ETF. (Of course, indexes are reconstituted by a committee of people, so we don’t know in advance what they’ll do. However, an index follows some general rules systematically.)

Therefore, if we discover an ETF we believe has a strategy and return stream that we want access to, then we would add it, whether it’s active or not.

 

The U.S. economy is [in the extreme late stages of the economic cycle], and no doubt, the easy money has been made. The Fed has embarked on a tightening cycle, liquidity is being taken out of the system globally, dispersion is rising, and global cross-asset correlations are at attractive levels—all of which provide a significant tail wind for active managers.

In the fixed-income space, we’re utilizing the actively managed [SPDR Blackstone / GSO Senior Loan ETF] (SRLN) throughout several of our models. The senior loan space is an area where you want the expertise of time-tested active management, which SRLN has proven for the past five years.

I am less optimistic about “traditional” actively managed equity and fixed-income ETFs. But we’re also utilizing several factor-based strategy ETFs—smart-beta funds, which some argue are the new form of active management. We believe market-cap-weighted indices are vulnerable to growth rotations and spikes in volatility.

We prefer tilting the portfolio towards quality, low volatility and value stocks—because they provide a greater margin of safety, and we think these factors should do well in this stage of the cycle. Moreover, we prefer combining other factors (momentum, carry) to construct a diversified portfolio with the goal of producing attractive risk-adjusted returns over varying economic cycles.

Traditional stock-picking strategies will continue to face an uphill battle given endless amounts of structural and secular forces. We prefer quantitatively driven ETF strategies that are systematized with a viable track record. Active management of these quant strategies in an ETF wrapper is the true sweet spot for investors.

 

Active ETFs have become a useful tool in our portfolio construction. While many individual clients and institutions are well-served with beta and passive portfolios, we find active ETFs can offer the ability to target the specific needs of a given client.

While we often use active ETFs as a complement to beta in portfolio construction, in the right situation, they can be useful to target specific income requirements, volatility mandates, or alpha opportunities that are more specific than the passive indexes themselves. There are many great products at the moment that use seasoned managers or strategies and that can add a layer of sophistication to a portfolio that has more unique needs than traditional “buy and hold.”

 

Find your next ETF

CLEAR FILTER