Quirky Working In These Active ETFs

July 10, 2017

[This article appears in our August 2017 issue of ETF Report.]

Sector investors are no strangers to active management. Indeed, the very act of slicing and dicing the market usually presupposes at least some specialized expertise. After all, you can't just take a chain saw to a broad-market index and expect to end up with an investable product.

Yet by our count, there are only 10 sector equity ETFs that classify as truly "active" (see Figure 1).

 

Figure 1. Top Active Sector ETFs

Source: ETF.com, as of 6/30/2017

 

Together, these funds have amassed $2.3 billion in assets under management (AUM)—a drop in the bucket compared with the $100 billion Select Sector SPDRs.

The story isn't the size of their assets, however, but the pace at which they're growing: $575 million has flowed into active sector ETFs since Jan. 1, or just under one quarter of combined AUM.

It's not hard to see why. With the exception of the real estate funds (and DFNL, which is only a few months old), all these active ETFs have outpaced their sector benchmarks, at least over the past year (see Figure 2).

 

Figure 2. Leading Active Sector ETFs' Performance

ETFExplainerFCG

For a larger view, please click on the image above.

 

Source: ETF.com, as of 6/30/2017

 

Granted, most of these ETFs are relatively new, with less than three years' track record, so it's impossible to say whether their outperformance will hold long term. (When it comes to active management, time is nobody's friend; research shows that over 15-year periods, 90% of active managers miss their benchmarks.)

Still, for now, these active managers are clearly doing something right.

But that's not the end of the story.

Big Alpha For Active MLP ETFs

Most flows into active sector ETFs concentrate into two funds: the First Trust North American Energy Infrastructure Fund (EMLP) and the InfraCap MLP ETF (AMZA).

Historically, active management has played a big role in commodities and commodity-adjacent assets like MLPs, because these markets can be frustratingly complex.  

"With any commodity-sensitive portfolio, active managers add value just by managing risk," said Ryan Issakainen, senior vice president and ETF Strategist for First Trust.

Although EMLP and AMZA are commonly lumped together, they're fairly different. For starters, EMLP is actually not an MLP fund. (Yes, the ticker threw us, too.)

 

Portfolio Mash-Up

Instead, EMLP is an energy equity ETF with a strong infrastructure tilt. Its portfolio is a mash-up of pipelines, utilities and Canadian income trusts; just 25% is in MLPs.

That makes comparing EMLP to index MLP funds a bit like comparing Apple Jacks to apples. But neither is it fair to compare EMLP to other energy equity ETFs, since the fund's managers specifically pick noncyclical securities for their relative immunity to oil and gas prices.

However you classify EMLP, it’s done remarkably well over its lifetime. The ETF has outperformed our MLP benchmark, the Alerian MLP Index, by almost 13% over the past three years. It's also outpaced all other energy equity ETFs over the past five years. Says Issakainen: "Knowing which securities to avoid and which to buy is key."

Compare that with AMZA, which offers much purer exposure to MLPs. The fund's managers handpick 25-50 MLPs, selecting for undervalued companies that post strong quarterly cash distributions. (That's important, because AMZA's C-corp structure means gains are taxed, but distributions are tax-deferred.)

With a scant 2.7% improvement over the Alerian MLP Index, AMZA hasn't captured the same outperformance as EMLP. But AMZA offers something EMLP doesn't: sky-high yields. As of late June 2017, AMZA yielded 22%, making it the highest-yielding ETF in any asset class, active or not.

Still, one of these two ETFs hews closer to the MLP sector than the other—and it's also the fund posting more modest gains.

ARK-ing To The Stratosphere

A similar oddity occurs in ARK Invest's suite of active ETFs. These "disruptive innovation" funds eschew the idea of sectors entirely; instead, it seeks exposure to transformative technology platforms. Think robotics, for example, or cloud computing.

"We believe traditional sector silos are rapidly becoming outdated," said Tom Staudt, ARK's director of product development. "The economy simply can't be modeled by sectors anymore."

Three ARK ETFs zero in on a different technology platform, while a fourth, the ARK Innovation ETF (ARKK), compiles the three strategies:

 

All four ETFs have blown away our sector benchmarks over one year—particularly ARKK, which outpaced the MSCI ACWI + Frontier Markets Investable Market Index by 28%. ARKK doesn't look anything like that benchmark though; instead, it features high allocations to tech stocks, health care and consumer cyclicals.  

Compare that to the purest-play ARK ETF, ARKG. With 67% of holdings in biotech and another 21% in health care, ARKG's portfolio most closely matches the traditional concept of a sector ETF (namely, biotech). And interestingly, ARKG's performance also most closely tracks market performance—though it’s still beaten our sector benchmark by 9% over the past year.

Narrow Mandates

There's an additional complication. ARK's funds have unique and extremely narrow mandates to satisfy, yet many qualifying companies are so huge that these particular business lines represent a paltry fraction of their revenues.

Take ARKQ, the automation fund; its largest holding is Tesla (11%). Yes, Tesla dabbles in self-driven cars, but it's also a car company, first and foremost, and thus subject to automobile industry trends.

To be sure, this problem isn't unique to active ETFs; index thematic ETFs struggle with the mandate question as well. (Staudt says ARK compensates by weighting companies according to their "thematic relevance," among other metrics.)

But it could partially explain why ARK's ETFs have walloped our benchmarks so soundly—and why ARKG, whose portfolio more closely mirrors a traditional sector—has posted humbler outperformance.

 

Modest Gains For Utilities

What about active sector ETFs that aren't trying to reinvent the wheel? Do they still outperform?

The Reaves Utilities ETF (UTES) is about as pure-play an active sector ETF as they come It just tracks utilities, utilities, utilities. Reaves Asset Management boasts more than 50 years of tracking the utilities sector, and as such, there are few gimmicks to UTES' portfolio—just stock picks backed by decades of experience.

That said, UTES' short-term performance doesn't exactly bowl you over. Over a one-year period, the fund has improved just 2% on our sector benchmark, the Thomson Reuters US Utilities Index. That's not much, especially after UTES' 95 bps fee.   

But it's the long game that matters, says Tom Grimes, head of institutional sales for Reaves Asset Management. "The daily returns of our fund versus the S&P 500 Utilities Index are very highly correlated: 98 to 99%. Over time, however, by adding a few outperformers here and avoiding losing names, we manage to outperform."

To that point, UTES forgoes some big utilities, like Duke Energy and Dominion Energy, while including regional players like Atmos Energy and Portland General Electric. It doesn't look a lot like the market indexes that underpin competitors like the Utilities Select Sector SPDR Fund (XLU) or the Vanguard Utilities ETF (VPU), but it hasn't left those ETFs in the dust, either.

Weirdness Pays Off

A pattern appears to be emerging: The active sector ETFs that outperform are the ones that actually defy their sector classification, like EMLP or ARKQ. Those that stick closer to traditional sector definitions—UTES, AMZA, ARKG—also more closely resemble market performance.

Active management finds its niche, it seems, in the spaces between sectors—where traditional definitions fall apart and things get a little weird. There's great opportunity in weirdness, but great risk as well.

As usual, know your limits.

 

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