Active, Passive Or Smart Beta ETFs?

We use all three—smart beta, plain vanilla passive and active ETFs—across our portfolios for various reasons. We believe that, in some places, it doesn’t make sense to be anything but passive. Specifically with bonds and alternatives, we use active bonds and liquid alts in our portfolios. Both areas are very difficult to replicate in a passive way.

We also manage our portfolios from a tactical perspective. So at times, depending on market conditions and where we think we are in the economic cycle, we’ll use smart beta. It might be we want to have a quality tilt or we might want to have a value tilt.

All of those things come into play when we’re putting together our portfolios.

Currently I use plain vanilla ETF strategies. I’ve built them into my model portfolios where I use a mix of active and passive funds.

So far, I only use mutual funds for the active strategies and only in qualified accounts for tax efficiency. I’ve seen no reason to change this as of yet, but I remain open to new ideas that will benefit my clients. I prefer the tax efficiency and lower fees of ETFs over mutual funds in general.

Our firm uses mainly plain vanilla (or market capitalization) weighted ETFs. Why? For the simple reason that we believe more value can be added through active asset allocation rather than tinkering with the underlying index. It’s better to spend time on being in the right asset class than the right index.

Consider that investors now widely recognize the benefits of the ETF product structure: low cost, tax efficiency, etc. We are all believers.

But many are moving beyond that. The primary benefit of ETFs has caused a paradigm shift for active investors; that is, ETFs have colonized the world’s asset classes and increased the portfolio-building conveniences of accessing them.

That means the smart money is now focused on establishing the right investment processes to build ETF portfolios. That’s a challenge in an industry in which many have developed skill sets in “single silo” stock picking (e.g., they labor only in one asset class). And much of the legacy portfolio architecture erected in the 1980s and 1990s (i.e., a focus on stock picking) remains in place.

ETFs, with their extensive global reach, offer so much more for active management. Portfolio managers can establish strategies based on a wide variety of asset classes, macroeconomic regimes and behavioral conditions. The ultimate goal should be to make active decisions where it counts most.

3D/L Capital believes that most of the risk premiums in publicly traded assets (equities, fixed income, commodities) may be captured systematically through index-based products, whether via plain vanilla indices constructed on market capitalization, or smart beta indices constructed on time-tested academically sourced risk factors such as value, size, momentum, dividend and quality.

In addition, the advent of artificial intelligence has led to thematic indices built around natural language processes and textual algorithms to determine index eligibility, allowing for more efficient capture of investment themes due to nuances that may be overlooked from standard industry categorizations (e.g., GICS).

From time to time, we’ll look to active management in areas that are more challenging to systematically capture risk premiums, such as leveraged loans, or when general risk premiums have largely compressed to the point that incremental value added comes from actively traded portfolios.

The fixed income market is a current example of the latter. Credit risk premiums have compressed to such historically rich levels that security selection and trading may be more important than just investing in credit risk beta.

We use factor-based ETFs when constructing our multi-asset ETF portfolios. Factor ETFs are a form of active management put in a rules-based systematic form, which is something our firm believes in. We don’t use [truly] active ETFs per se, mainly because we prefer to understand exactly what’s under the hood of our ETFs and all the risk exposures.

There may be an instance where one of our fixed-income-oriented portfolios will use [something like the PIMCO Enhanced Short Maturity Active ETF (MINT) or the JPMorgan Ultra-Short Income ETF (JPST)], but they tend to be small [allocations].
Active ETFs tend to have a much smaller place in our multi-asset ETF portfolios. We’ll look at active fixed income ETFs more in our fixed-income-heavy portfolios. I know the world wants nontransparent active ETFs, and most of the big active fund families are going to start launching ETFs. And they should—it doesn’t mean that they won’t be successful.

We’re an active management advisory firm—we just tend to use rules-based, systematic factor-based ETFs, and then we tilt our portfolios as macroeconomic conditions change. We think there’ll be a place for [actively managed nontransparent ETFs] for those advisors that don’t want to actively manage their portfolios themselves.