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%.

 

Alternative To Active Dividend Funds

Alternatively, investors could have just invested in one of several dividend-focused ETFs. The Vanguard Dividend Appreciation Index Fund (VIG | A-75) is up 8.17% through June 30, and is relatively inexpensive, at 0.09%.

This post is intended to defend active management, which it does later on. However, the point of this post is not so much to highlight the persistent underperformance of active funds—particularly against low-cost ETF options—but to show that much of what active management delivers can be captured with low-cost ETF options.

More importantly, such ETFs can provide useful secondary benchmarks to assess the value-added of active managers above and beyond the market exposures (strategic betas) that can be replicated using low-cost ETFs.

Active Management In A Box

One benefit of ETFs (perhaps unintended) is the increased understanding of what traditional active management is trying to deliver. In "Why ETFs (and Why Strategic Beta ETFs)?," we introduced this notion of strategic beta representing "active management in a box." Specifically, we wrote:

"Most of what you get from a typical active manager can be systematically captured in a rules-based approach. For active growth managers, just buy momentum and quality factors. For active value managers, just buy 'value' and dividend factors. For an all-in-solution, buy a multi-factor ETF where the diversification amongst the individual factors produces a return profile where the whole is greater than the sum of the parts. And you can easily capture the size premium that comes with most active managers as they tend to exhibit a smaller cap profile than traditional cap-weighted indices."

'Factor Extractor'

Other ETF providers have picked up this notion, such as iShares, which recently introduced a new analytical tool called "Factor Extractor." I saw a demonstration of this at an iShares Investor Symposium held this past January. Using BlackRock's Aladdin risk model, Factor Extractor enables an investor to load in a traditional mutual fund and "extract" how much of the risk and return can be sourced from common risk factors such as size, value, momentum, yield, quality and low volatility.

What remains can then be attributed to factor timing and/or security selection. Factor Extractor is only available for U.S. market analysis, but, based on conversations with iShares, the analytical tool should be expanded to the international markets later this year.

As investors come to appreciate how ETFs—particularly strategic-beta ETFs—have democratized the investment landscape, they will also appreciate the additional level of insight such ETFs bring to traditional active management. By isolating the common factor risks embedded within traditional active management, investors can better understand the value that is being delivered from a mutual fund manager's investment insight.

The challenge then for active managers is to deliver performance that is not easily replicated with strategic-beta ETFs; otherwise, investors can gain much of the returns of "active management" at a fraction of the cost of what typical active mutual funds are charging.

 

Why Investors Still Need Active Management

Imagine you are the CEO of a small or midsize publicly traded company and you pull up your latest 13D to find that your top shareholders aren't some of the active management industry leaders such as Fidelity, Wellington, American Funds, T. Rowe Price, but instead, leading passive/index providers such as Vanguard, BlackRock, State Street and Northern Trust. How do you know if your equity (or debt) is being valued appropriately when you go to raise more capital?

How do you know if your business strategy is going to generate competitive value for your shareholders?

I posed this question to none other than BlackRock CEO Larry Fink at the iShares Investor Symposium. He, more or less, dismissed this as an immaterial concern, since actively run assets still comprise the vast bulk of overall assets under management, and BlackRock's top shareholders included the likes of Wellington and Fidelity.

However, the bleeding of assets from actively managed funds continues, with the Investment Company Institute reporting that long-term mutual funds posted net outflows of $2.09 billion in the week ending July 6.

And according to Stifel Nicolaus, for the week ending July 12, the combined inflows to the highest-profile index ETFs—the SPDR S&P 500 ETF Trust (SPY | A-97), the SPDR Dow Jones Industrial Average ETF Trust (DIA | A-83), the PowerShares QQQ Trust (QQQ | A-66) and the iShares Russell 2000 ETF (IWM | A-91)—reached $11 billion, the most since September 2015.

Perhaps the 13D list of primary shareholders is not a concern for a high-profile, well-respected company like BlackRock, but for many smaller-cap companies—who are competing with each other for capital—the increasing number of passive index vehicles making up their main shareholder base will make it more difficult to price their equity and debt instruments.

And rather than interfacing with a professional portfolio manager or research analyst, company management will find themselves interfacing with an index committee or a shareholder proxy advocacy group employed by the index providers.

Active, professional managers help grease the gears of capital pricing, formation and allocation. In an extreme scenario of passive/index domination, the "market" becomes the main shareholder, as fewer professional investors will exist to bring a greater degree of expertise in evaluating businesses and assigning valuations to their prospects.

Finding The Right Balance

I understand that, in the end, investors should only care about returns rather than fulfilling some grander social purpose in maintaining the integrity of capital markets. However, a balance should be struck between passive and active.

We would argue that a portfolio of low-cost strategic-beta ETFs should form the core foundation of an investment program, with satellite allocations to higher-active-risk strategies, whether traditional management or tactical rotation strategies.

Doing so should help bring the overall cost of the investment program down while maintaining baseline exposure to much of the systematic risk embedded in traditional active management.

Alpha opportunities will always exist, but traditional active managers must clearly differentiate those aspects of their investment process that are not as easily replicated with lower-cost systematic beta investment vehicles, and then price that service accordingly.

At the time of this writing, 3D Asset Management did not hold any of the ETFs mentioned aboveMore detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm's Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing [email protected] or visiting 3D's website at www.3dadvisor.com. For a complete list of relevant disclosures, please click here.

 

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