[This article appears in our July 2019 issue of ETF Report.]
Actively managed ETFs are a small but growing field of the industry, and their issuers (naturally) say the time has finally come for these ETFs to offer investors a cheaper, transparent alternative to mutual funds and something besides passive indexing.
Some actively managed ETFs have delivered serious outperformance, such as the ARK Innovation ETF (ARKK), which ended 2018 on a positive note, and rose a staggering 87% in 2017. Others are still trying to establish an ETF track record that matches their own mutual fund history, like Davis Funds; while others, like Legg Mason, are teaming up with affiliates to launch products.
What makes these funds tick? Research, many of them say. So ETF Report took a look at several active funds out there to parse their strategies.
Top-Down, Long-Term Focus
ARK Funds, known for its focus on disruptive technologies, has five actively managed ETFs, with four feeding into the fifth: ARKK.
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Renato Leggi, client portfolio manager at ARK Funds, says ARKK holds the firm’s “best ideas” from their other strategies.
ARK Funds takes a top-down research process to identify innovative platforms or themes that have reached a tipping point in cost declines and have become cheap enough that exponential growth is possible, Leggi says: “That’s when we know these technologies are ready for prime time.”
The five technologies ARK Funds focus on are DNA sequencing, robotics, energy storage, artificial intelligence and blockchain, all of which have seen steep price declines, he explains. For example, when the first whole human genome was mapped in the early 2000s, it cost $2.7 billion, but today DNA sequencing is roughly $1,000 to $2,000.
Innovation is inherently controversial, Leggi says, and ARK Funds takes a different view toward these disruptive technologies than other active and passive ETF firms or Wall Street analysts. ARK looks for companies investing aggressively in research and development to gain long-term opportunities, and the firm seeks to hold companies for at least five years to give these companies time to gain future market share.
ARK’s long-term focus doesn’t mean simply buy and hold, he says. ARK trades actively, buying on dips and selling to rebalance, but not timing the market. It’s what drives the firm’s outperformance, and how ARKK ended 2018 up 3.5%, rather than being flat, Leggi notes.
Using its No. 1 holding, Tesla, as an example, Leggi says that, had ARK Funds simply bought and held Tesla for the full year, the stock would have contributed less than 0.2% to the firm’s overall performance.
By trading around Tesla news, such as when founder Elon Musk tweeted about going private, the firm added 1.76% of alpha to the portfolio return, Leggi says. Ultimately, ARK Funds did that with several names, trading around volatility and market noise, he notes, which added about 3.2% to the portfolio’s performance.
Tesla is another example of how ARK Funds views its holdings differently. Leggi says the firm covers Tesla from the perspective of a company involved in electric vehicles and battery technology, autonomous vehicles and artificial intelligence, rather than as an automotive company, which is how it’s usually analyzed.
“Many of the names we own, we own for a much different reason than the broader market,” he explained.
What—Or What NOT—To Buy
Davis ETFs launched active ETFs about two years ago, but is incorporating similar strategies to those used by Davis’ mutual funds, which have been around for about 50 years. The firm has four different ETFs, with the Davis Select Worldwide ETF (DWLD) the largest, at nearly $209 million.
Chris Davis, portfolio manager for the Davis Select U.S. Equity ETF (DUSA), says that while the funds themselves have different strategies, the firm’s overarching theme for portfolio construction is that avoiding certain investments is just as important as what to include.
“Choosing not to own certain things can be a huge advantage, [as is] actively determining what to own,” Davis said.
Davis says the firm’s strategy to both actively avoid and actively add stocks is easiest to see in DWLD and the Davis Select International ETF (DINT). Davis Funds shuns state-owned or formerly stated-owned enterprises, because the ETF provider believes these firms have historically poor returns and no culture of value creation or entrepreneurial spirit.
When it comes to what to own, Davis points to the firm’s approach to emerging markets, a tag that he says can be a misnomer. For Davis Funds, China is not an emerging market, being the second-largest economy globally. “I think it’s emerged,” Davis said.
He notes that the company owns a Bermudian bank that’s more than 200 years old, and that Bermuda, which is one of the most stable countries in the world, is labeled an emerging market. “You get these strange mischaracterizations,” Davis added. “Which countries to own and not to own is part of active management.”
Although the Davis ETFs had a difficult 2017, he says the track record of the firm’s mutual funds shows its strategies work: “I think our offering is credible, because we have a long history of adding value over the index.”
Picking Strong Managers
Ambar Bajaj, director, ETF product management at Legg Mason, which has five active ETFs, says the firm’s approach to launching active ETFs is to tap into the expertise of independent investment manager affiliates like ClearBridge and Western Asset, and launch strategies through them.
Managers like ClearBridge and Western Asset are Legg Mason companies, with decades of active management experience, Bajaj says, and the ETFs Legg Mason launches with them “reflect what we think the market needs and how it aligns with our capabilities.”
Many actively managed funds are in fixed income, which isn’t a surprise. Ryan Issakainen, ETF strategist for First Trust, says that from a product development and strategy standpoint, it’s a little harder to do active management for some categories, like a large cap U.S. equity fund. About 80% of the firm’s actively managed ETFs are in fixed income.
He says that as First Trust seeks to launch products, it looks for strong managers with outperformance, in addition to flaws in the passive approach.
Exploiting Higher Spreads
David Braun, co-manager of PIMCO’s Active Bond ETF (BOND), says by actively positioning outside of the Bloomberg Barclays US Aggregate Bond Index, the firm can buy the less-well-owned securities to take advantage of higher spreads. Doing so also lets PIMCO diversify from the index’s three main asset classes.
“Diversification is one of the few free lunches out there,” Braun said. “Often, you can increase your reward potential and your yield at the same time.”
Right now, PIMCO is finding value in agency and nonagency mortgages, plus other asset-backed securities, he adds.
While fixed income is a focus for a number of actively managed ETFs, Paul Kim, managing director, ETF strategy at Principal Global Investors, which has five active ETFs, says income is not a universal one-size fit: “Income is generating regular income payments or dividends on different types of risks.”
An example of that is the Principal Active Income ETF (YLD), a multi-asset strategy mixing global equities and various types of debt vehicles. This strategy would be difficult to do in an index, Kim says. The fund looks for the best risk-adjusted returns using fundamental credit research within an asset class, and then searches across asset classes to find relative value.
“You overlay that with the portfolio manager who thinks about risk management,” he explained. “And then you have what we view as a strong multi-asset approach to income.”