Don’t Be Starstruck By A ‘5 Star’ ETF

Today’s headlines on these quant/active strategies have us scratching our heads.

This morning’s email box had a press release from AdvisorShares, touting its pleasure at receiving a “5 Star” rating from Morningstar for its Madrona Forward Domestic ETF (FWDD | D-74).

And hey, that’s great. I love to see ETF issuers, particularly smaller ones, being successful in the marketplace. But then I started thinking it through.

Let me be clear, there’s nothing wrong with FWDD. It’s a traditional, actively managed fund. Its manager, Madrona Funds, picks stocks based on analyst estimates. As active management goes, it’s about as tried and true a stock-picking methodology as any other. Still, over the very long term, there’s not much evidence that simply weighting IBES data beats the market.

But hey, the fund has managed to beat the S&P 500 Index, right?

That’s no mean trick, so surely it’s got to be worth the annual fee of 1.25 percent ($125 for each $10,000 invested).

Well, not so fast. Let’s look at how the fund’s portfolio compares WITH our neutral benchmark for large-cap funds (from the “Fit” tab for FWDD):

The question in analyzing any ETF, especially one trying to be a better mousetrap, is: “What’s this fund doing that’s different?” In this case, it’s pretty easy to see. It’s not really being a large-cap fund. Its average market cap is massively lower than the raw benchmark, and the fund is actually 35 percent in midcap stocks.

If you look at the holdings overlay, the fund holds nearly every single stock in the large-cap universe—but it also holds a ton of other stuff. A glance at the top five holdings reveals an even more telling factor:

It should be pretty obvious that this fund is employing some form of equal weighting, and indeed, there’s a tiered-and-capped system in place, where no security can be more than 0.75 percent of the portfolio. I’ve talked about what equal-weighting schemes do for you in a portfolio many times.

But really, the core benefits come from skewing down the cap spectrum, and from rebalancing (selling your winners to invest in laggards). These are totally valid strategies, but they simply skew the portfolio. They skew it toward midcaps, and they tend to increase your beta. And in fact, that’s just what the statistics show:

Up/down beta is perhaps my favorite statistic in finance for understanding how a given strategy will perform relative to a benchmark. FWDD’s beta of 1.08 suggests “this fund is pretty much like taking 8 percent leverage on the benchmark.”

But the up/down numbers suggest how you get there. They suggest that on up days, the fund is just slightly leveraged to the market, but on down days, watch out. That’s the opposite of the kind of thing you’d like to see. After all, aren’t all of us interested in maximizing upside while avoiding the downside?

How then does this fund outperform in the past three years? It beat the S&P! The magic number for getting your Morningstar rating? Well, to start with, there just haven’t been that many down days. But secondly: It’s the magic of equal weighting in an up market:

If you can’t tease out the performance stat for the comparison I’m making here—the Guggenheim S&P 500 Equal Weight ETF (RSP | A-80) from this chart—it’s because it’s hidden behind the label for FWDD—it’s a scant 30 basis points behind FWDD after five years.

And if you look back to the most volatile year in the period (2012), you can see what happened to both RSP and FWDD when things went south—they underperformed. FWDD, in fact, trailed significantly behind both the broader large-cap market and the naive mechanical approach of RSP. By the way, if you care about these things, RSP also has 5 stars from our friends at Morningstar. The stars are just mechanically assigned based on past performance, so of course they have the same stars.

So should you buy either of these funds? Well, there’s no free lunch in investing. In FWDD, you’re paying an enormous fee to tap the benefits of higher beta and equal weighting. You’re also doing it in a fund with almost no liquidity (700 shares a day trade on an average day). In RSP, you’re paying 40 basis points a year—less than one-third of FWDD’s expense ratio—for a fund that trades half a million shares a day.

Maybe I’m just getting old and cynical, but it’s hard for me to be starstruck by illiquid high-fee products delivering nearly identical returns to liquid low-cost index products. There’s no magic here. Just math.

At the time this article was written, the author held no position in the securities mentioned. You can reach Dave Nadig at [email protected], or follow him on Twitter at @DaveNadig.