ETF Strategists Turn Beta Into Alpha

June 05, 2014

Back To The Future

Given the hard lessons since the turn of the century, it's hardly a surprise that the index fund in a more transparent, cheaper and efficiently tradable ETF wrapper has been repurposed as the centerpiece of alpha-seeking strategies in and beyond the world of ETF strategists.

After all, the pursuit of outperformance is a reflection of an almost-elemental human impulse for control, and to see the future before it unfolds. And if that aim can be achieved in a manner that's cheaper and easier than with mutual funds and single-security selection, then ETF use becomes something of a no-brainer. That allure is even more powerful given the variety of approaches among ETF strategists.

"If you want to have something that's broadly diversified and has relatively low turnover, there are firms that do that," said Todd Rosenbluth, ETF analyst at S&P Capital IQ in New York. "If you want something that's more tactical, based on shifts in momentum or whatever is happening in the American economy, there are firms that can help you to do that. And if you want something that gets very granular with individual sectors and industries, there are ways do that too."

"So instead of just paying for a mutual fund and not knowing what they're doing, you know what they hold—an ETF is transparent," he noted, stressing that the top-down approach afforded by ETFs is clearly taking off, and has potential for much more development ahead.

These days, even Vanguard, the firm that launched the first retail index fund in the mid-1970s, has begun talking with investors about ways to use its ETFs to beat broad market indexes. Such a turn of events might irritate a pure-indexing pioneer like Vanguard's founder John Bogle, but make no mistake: Many—if not most—ETF strategists build their model port-folios around a core that's indexed.

And why wouldn't they? Academic research over the years—from Brinson, Hood and Beebower to Ibbotson and Kaplan—has clearly shown that the vast majority of returns (or, more precisely, the variability of returns), are generated by asset allocation decisions and not by a combination of timing, security selection, management fees and expenses.

So, ETF strategists have taken to using catchy marketing terms designed to convey the index-the-core approach, such as "beta-plus" favored by Main Management in San Francisco. In the end, they all echo the central idea of Schoenfeld's landmark book "Active Index Investing" a decade ago. And that is that indexing entire portfolios makes sense if you believe the peer-reviewed academic literature the way people like Rick Ferri do.

With the tide turning in favor of ETFs and the money management industry in full transition, ETF strategists such as John Forlines III, chairman of Long Island, N.Y.-based JAForlines Global, are now turning their attention to playing offense. They preach a gospel of ETF-based alpha generation, while looking forward to better index-based ways to managing both risks and returns.

"If you're an 'active indexer' like we are, ETFs are the best things we have to pursue the strategies that we pursue," Forlines said. "The real endgame is this: to put the kibosh on bottom-up stock and bond pickers. That bottom-up approach should be in hedge funds and specialized boutiques, where it used to be."


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