Here’s How Active Can Compete With Low Cost ETFs

July 18, 2016

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 by Ben Lavine, chief investment officer of 3D Asset Management based in East Hartford, Connecticut.

Savita Subramanian, quantitative strategist at Bank of America Merrill Lynch, just published an update to the firm's periodic review of active managers. According to the report, "Just 18% of large cap funds outperformed the Russell 1000 in [the first half of 2016], so far making it the worst year for active funds in history."

I decided to construct a more refined list of active U.S. large-blend mutual funds in Morningstar, where I screened out multiple share classes, sector funds, passive funds and low/managed volatility. I arrived at a list of 347 funds where the median return for the first half of the year is 1.81% versus 3.84% for the S&P 500.

This ranks the index at 22% of the funds within this list, fairly close to the BofA observations. And for the privilege of realizing this underperformance, investors in this list of funds are paying an average fee of 0.67%.

Dividend-Focused Stocks Driving Returns

There are many market head winds facing managers this year (similar to what has been observed over the last several years). Despite a strong second quarter, small-caps continue to lag large-caps, with the Russell 2000 returning -1.59% versus 3.74% for the Russell 1000. This has also been a largely one-directional market, with dividend-focused equities (or bond proxies) generating the lion's share of U.S. equity returns.

S&P telecom and utilities have returned 24.8% and 23.4%, respectively, while traditional growth sectors such as consumer discretionary, health care, technology and financials have significantly lagged the broader market (Exhibit 1). Telecom and utilities tend to be underrepresented in active mutual funds, as indicated in Exhibit 2.

Exhibit 1 – 1H16 S&P Sector Returns: Safe and Defensive Has Been the Place to Be

 

Exhibit 2 – U.S. Large Cap Fund Median Sector Exposure Versus S&P 500 Index

Finally, it's been a one-directional market, with low-volatility/dividend strategies outperforming all other styles (Exhibit 3).

Exhibit 3: It's Been a One-Directional Market

 

Many of this year's top-performing funds have the label "dividend" embedded in the fund's name. I performed an additional filter where I only included funds with the word "dividend" in the funds' names. This produced a list of 26 funds in which the median return was 6.38%, much higher than both the broader list and the S&P.

For the privilege of investing in this group of funds, the investor pays an average expense ratio of 1.08%.

 

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