Measuring How Active Your ETF Is

Forget about whether it tracks an index. Just look at the numbers using Active Share and the ETF.com Fit score.

In the ETF world, the terms “active” and “passive” have been rendered almost meaningless by the proliferation of complex indexes.

True, the literal definitions remain intact: Passive ETFs track an index; active ETFs don’t.

But it’s hard to argue that this distinction matters much today, especially in the context of U.S. equities. That’s because index-tracking ETFs in the U.S. equity space deliver a mind-numbing variety of exposures—low volatility, share buybacks, relative strength, risk parity and quality, to name a few.

Confusing matters more is the existence of traditional plain-vanilla, cap-weighted indexes tracked by ETFs—vehicles that are passive in word and deed.

Still, even within the realm of nonvanilla index-based ETFs—whether you call them smart beta, factor-based or nontraditional—there’s a huge range of performance and exposure differences, some of which exceed the bets made by active ETFs.

Unfortunately, the label on the box often tells you little about how big a bet the ETF is making relative to the market. So it makes sense to look at numbers rather than words to tell how today’s wide-ranging index-tracking ETFs stand up next to both plain-vanilla ETFs and actively managed ETFs.

Measuring Up With ‘Active Share’

Two readily available tools can help. The first is Active Share. Active Share, described in a paper by Antii Petajisto, simply measures the holdings overlap between a fund and its benchmark. A high Active Share means that the fund and the benchmark diverge significantly with respect to the actual stocks in their baskets.

While Active Share shouldn’t be the only tool for portfolio comparison (as the author makes plain), it provides insight into the range of variation among passive and active ETFs relative to a cap-weighted benchmark. It’s also useful when the performance history is limited—as is the case with some of the active ETFs shown below.

Following below is a table showing the Active Share for a variety of ETFs, culled from the relatively narrow confines of U.S. large-cap and U.S. total market spaces. I included popular smart-beta index-based ETFs, all of the active ETFs (there aren’t many)—highlighted in blue—and a pair of cap-weighted funds in bold for reference.

(I selected the nonvanilla passive funds ranked by assets under management down to about $500 million, and I selected all active ETFs in the space regardless of size. I arbitrarily excluded growth, value and high-dividend ETFs.)

Clearly the most active funds on this list as measured by Active Share—those that deviate most from the market—aren’t actively managed. The Guggenheim Spin-Off ETF (CSD | C-43) and the First Trust US IPO Fund (FPX | B-49), for example, each make bold portfolio departures from a cap-weighted benchmark, all the while tracking their respective indexes.

Meanwhile, the actively managed funds—highlighted in blue—vary greatly regarding how much they differ from a vanilla benchmark. The AdvisorShares TrimTabs Float Shrink ETF (TTFS | B-80) tops this list with an Active Share of 84 percent, while the Huntington U.S. Equity Rotation Strategy ETF (HUSE | C-89), with its 39 percent score, might be called a closet indexer.

Based on Active Share, it’s clear that “passive” doesn’t always mean marketlike, and that “active” doesn’t always mean huge deviations from the market.

Side note: Active Share for every equity ETF is easy to get from ETF.com fund reports. On the “Fit” tab and halfway down on the right, you’ll see “Shared Holdings” as well as a weight percentage. To get the Active Share, simply subtract the weight percentage from 1. Active Share = (1 - ETF.com Shared Holdings Weight %).

Keeping Fit

Portfolio overlap is only one small part of determining how big an ETF’s active bets are, which brings us to the second tool for seeing how much an ETF varies from a neutral benchmark.

The author of the Active Share paper includes a performance component in his analysis. This two-pronged approach—holdings assessment and performance analysis relative to a benchmark—also lies at the heart of ETF.com’s Fit scores.

Active Share and the Fit score tell a similar story but move in opposite directions: An ETF that makes big bets away from a cap-weighted benchmark will typically have high Active Share and low Fit score.

Here’s a table showing the ETF.com Fit score for this same sample of funds. It confirms the main thesis above; namely, that some passive ETFs make much bigger bets than some active ETFs. I’ve suppressed the Fit score for three funds that have less than six months of data, but I ranked them on their calculated score with the available history.

An anomaly worth mentioning is that the PowerShares Buyback Achievers Portfolio (PKW | A-92) is gaining a whopping 24 extra Fit score points for risk-adjusted outperformance over multiple periods, a rarity that’s worthy of its own blog.

Performance Peek

So far we’ve looked at two methods supporting the idea that some indexes make huge bets against the market. Lest I get too pointy-headed here, I added a quick performance snapshot below simply showing return and risk—12-month total return and beta to cap-weighted benchmarks.

Note that the already-tiny number of active ETFs in the space includes four funds with less than 12 months of history, and therefore aren’t shown on the table above.

What I’m trying to show with this snapshot is the wide range of results for the remaining funds with respect to both return and risk as measured by beta. Generally, the funds with higher beta have higher returns than the cap-weighted funds (in bold) in the recent uptrending market, regardless of whether they’re active or passive—no surprise there.

All In

In short, the textbook definition of passive and active index just doesn’t tell you much about an ETF’s exposure—at least in the narrow, but important, realm of U.S. large-cap and all-cap equities.

So what does the distinction mean? Actively managed funds have the capacity for flexibility—to be more nimble and more responsive to unforeseen events. They’re likely better vehicles for truly skilled stock pickers whose methods don’t fit into a set of rules.

Conversely, the passive-in-name, but active-in-spirit ETFs offer discipline with a capital “D”: no style drift, no emotional response, no investing on a hunch.

Also, active ETFs are much larger players in the bond space, where markets are less efficient.

Lastly, I believe that funds that make subtle tilts away from the market—whether passive or active—have their place in a portfolio, provided their fees are competitive. They’re more suitable for core and long-term allocations while big bets work best as tactical plays, overlays and the “satellite” part of the portfolio.

At the time this article was written, the author held no position in the securities mentioned. Contact Paul Britt at [email protected] or follow him on Twitter @PaulBritt_ETF.