Complete The Core With Specialty ETFs

January 08, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is co-authored by Mike Venuto, co-founder and chief investment officer; and David Dziekanski, portfolio manager, at New York-based Toroso Investments.

 

 

In the past decade, the indexing business has moved from a benchmarking business to an investable universe and an asset-gathering business, in large part, because of the growth of the ETF industry. Still, the sometimes-complex worlds of indexing and ETFs have left some stocks out of major indexes and funds, creating gaps in exposure for investors.

 

The question then becomes, how should investors fill this blind spot? But before turning to focusing on ways of solving this problem, an example or two is in order.

 

First, companies with high levels of inside ownership receive decreased weightings in most of the major index companies. Also, many securities are being excluded from mainstream indexes due to certain indexing rules. This issue was highlighted recently by the largest IPO in history, Alibaba Group Holding Limited (NYSE: BABA). Specifically, geographic rules of popular emerging market indexes excluded this highly sought-after new issue.

 

So how can investors fix this and own Alibaba or some other prospective stock in a fund structure?

 

Are Active ETFs The Answer?

Many look to active management to provide access to the securities orphaned by ETFs and the sought-after excess returns. In 2014, there was a constant flow of headlines about active ETFs and SEC rulings. Toroso believes this obscures the real opportunity.

 

Active ETF management, in our opinion, faces a substantial hurdle that will not be solved through an ETF structure. The success of an active ETF hinges on two viability statistics that are difficult to achieve simultaneously, since one begets the other: trading volume and performance.

 

Instead of trying to fit active management into an ETF format that is dependent on trading volume, we feel the real story lies with the ETFs in what we call the “business characteristics” space. This approach provides access to those characteristics that active managers target, but in a passive, more transparent format.

 

We have identified 22 such ETFs, which we’ve listed in the appendix below.

 

Targeted Access

Business-characteristic ETFs are designed to provide passive access to investment strategies used by hedge fund managers and billionaires. Some focus on corporate actions, share-repurchase programs, spinoffs, insider sentiment and product life cycles, just to name a few.

 

These ETFs allow passive investors access to market nuances that active managers seek out in a low-cost, transparent and tax-efficient manner. In other words, we believe business-characteristic ETFs are better links between active and passive management.

 

Examining the Overlap

We define “overlap” as the percentage of the ETF that is contained or represented by an ETF to which it is being compared. The chart below compares the percentage overlap for a selection of U.S.-only business-characteristic ETFs to the broad equity market represented by the SPDR S&P 500 ETF (SPY | A-98).

 

 

These ETFs can provide access to the securities and themes for which active managers will often pay a premium to purchase.

 

Domestic Business Characteristic ETFs

ETFs Based on the Actions of Others:

All these funds seek to provide exposure to the conviction holdings of hedge funds or billionaires. Each of these takes different approaches to execution; most are equal-weighted and focus on equities of all capitalizations, but with a large-cap bias. However, GURX from Global X Funds is dedicated to small-caps.

Also, AlphaClone’s ALFA is unique in that it has a built-in hedging mechanism that is triggered by moving averages, and is weighted based on hedge fund conviction. The commonality has been excess returns as evidenced by ALFA and GURU, which have the longest history:

 

 

ETFs Based on the Actions of Insiders:

 

Both of these funds come from two different ETF sponsors and use the same index provider, Sabrient Systems LLC. Amazingly, these two funds with seemingly similar mandates and a common index provider only have 19 percent holdings overlap to each other.

 

Again, the commonality is performance, but the interesting observation is tax efficiency. KNOW, for example, has 920 percent turnover according to Morningstar; and in 2013, the fund was up 33 percent with no capital gains distribution.

 

ETFs Based on the Actions of the Companies

 

Many of the other business-characteristic ETFs focus on the actions of the companies themselves:

 

 

Additionally, the fund market includes two other ETFs that focus on U.S. IPOs. They are “IPO” ETFs:

Surprisingly, these two ETFs only have 18 percent holdings overlap.

 

Completing The Core

Toroso uses business-characteristic ETFs to complete and enhance portfolios of our clients. We strive to get exposure to underowned, opportunistic securities through careful analysis of these so-called business-characteristic ETFs. By pairing traditional market-cap, index-based ETFs with ETFs tied to business-characteristic indexes, we build portfolios that may behave like actively managed funds, but at a lower cost.

 

ETFs have risen to prominence due to their low costs, ease of trade, transparency and tax efficiency. Our excitement about the business-characteristic category is not to discredit to the original concept. But it does allow savvy investment managers the opportunity to outperform traditional index-based strategies in two possible ways:

 

  1. Overuse of traditional market-weighted index strategies may reduce their effectiveness in helping investors reach their investment return goals.
  2. By identifying “alpha”-seeking, concentrated ETFs that follow many of the techniques employed by active managers, but in a passive ETF format.

 

We believe the solution to mainstream index exclusion and diminishing returns does not begin with the active ETF structure debate. Many solutions already exist in the business-characteristic-based ETF category; the true challenge is to properly use this growing segment of the vibrant world of ETFs.

 

 

At the time this article was written, Toroso owned shares of PKW and CSD on behalf of clients as part of core portfolios.


Toroso is a New York-based investment advisor focused on researching ETFs and other exchange-traded products and designing asset allocation strategies, using ETFs, which seek to perform well in various economic climates while emphasizing future objectives over past correlations. For more information about Toroso, call us at 646-545-5195, visit us at www.torosoinv.com or email us at [email protected]. For a list of relevant disclosures, please click here.

 

 

Find your next ETF

Reset All