ETF Strategists Turn Beta Into Alpha

June 05, 2014

Who knew the humble index fund would turn into an alpha generator?

[This article originally appeared in the June issue of the ETF Report.]

Perhaps it was inevitable that the exchange-traded fund would evolve and expand from its original function. It has transformed from a way to easily canvass a single broad asset class such as U.S. equities through a single trade into an efficient way to canvass all asset classes in the pursuit of alpha.

And perhaps it was inevitable that a new class of financial advisors would emerge that would develop and spread to other advisors this concept of "alpha through beta." Indexing pioneer Steven Schoenfeld presciently described at length this idea in his classic 2004 tome "Active Index Investing."

Money keeps pouring in to ETFs as it becomes clear that using this type of cheap, transparent and highly liquid fund with a top-down macro approach is really a better path to asset-allocation investing than using more expensive mutual funds or overly granular individual securities. The growing army of so-called ETF strategists that design active-index portfolios using ETFs and market them to other advisors is steadily moving to center stage in the world of money management.

The latter trend is hardly a surprise. Anyone with experience in the brass-knuckles sales culture of the financial services industry knows that landing clients and thoughtfully running money with a rigorous eye on asset allocation are about as different as night and day. But both are full-time jobs, so the division of labor at the center of the value proposition that ETF strategists offer makes a whole lot of sense.

In any case, you can't argue with the numbers. Assets in U.S.-listed ETFs are rapidly approaching $2 trillion, and hedge funds are increasingly making use of ETFs in their pursuit of outperformance. That's a clear shift away from the stock picking favored by yesteryear's star managers like Peter Lynch at Fidelity's Magellan Fund.

According to Morningstar research, assets in ETF model portfolios marketed by ETF strategists grew by about 40% last year to just shy of $100 billion—almost 6% of the $1.701 trillion that was in U.S.-listed ETFs at the end of 2013. That stellar growth rate came on top of a 50% growth rate in 2012, Morningstar said.

By comparison, assets in U.S.-listed ETFs as a whole rose by 26% in 2013 and 27% in 2012—both well below growth rates in the ETF strategist space, thus demonstrating that ETF strategists are an engine of ETF growth.


Andrew Gogerty, the former Morningstar analyst who compiled those data before he left the Chicago-based fund research firm, told ETF Report that while the growth rate is sure to tail off as assets in ETF model portfolios grow, the percentage of the ETF asset pie coming from ETF strategists will almost surely double in the next five years, and could even triple.

"If you think about the value that these strategies provide to a financial advisor or some type of intermediary as an outsourcing of functions of their day, it's very attractive," said Gogerty, who is now a vice president of investment strategies at Boston-based Newfound Research, an ETF strategist firm with about $20 billion in assets under advisement.

"If you look five years down the line, and predict that ETF managed portfolios will control anywhere from 10 to 20% of all ETF assets, I don't think that's unreasonable," said Gogerty.

Some advisors, such as Rick Ferri, president of Michigan-based Portfolio Solutions, aren't convinced the growth will materialize. Ferri, a pure indexer who hews to a straight-ahead "buy, hold and rebalance" approach to asset allocation, also questions the alpha generation that ETF strategists promise.

"There's no reason to believe that switching from picking stocks to picking ETFs is going to yield a better result," said Ferri.

Whether you agree with Ferri or not, if you're designing alpha-focused strategies, you'd be remiss if you didn't build the core of portfolios with cheap index ETFs, and complement that at the perimeter with more finely targeted or tilted ETF strategies and single securities.

From Insurgents To Apostles
The current rosy outlook for the ETF and for ETF strategists wasn't always a given.

In the early years after the first U.S. exchange-traded fund, the SPDR S&P 500 ETF (SPY | A-98), was brought to market in January 1993, there just weren't enough ETFs in existence to execute in any meaningful way the top-down global macro approach favored by ETF strategists.

But even a decade after SPY, with the arrival of the first batch of fixed-income strategies that made possible a credible attempt at rigorous asset allocation using ETFs, pioneering advisors who recognized the vast potential of the ETF were still bogged down educating prospects and clients.


"About five years ago, I would spend all my time—people would always be raising their hands—explaining what an ETF actually is," said Tyler Mordy, president and co-CIO of Hahn Investment Stewards, an ETF strategist firm based in Toronto with about $500 million in assets under management, all of it in ETFs.

Worse yet, practitioners using ETFs have found themselves defending the ETF, all while trying to explain its potential to democratize access to global financial markets. As recently as three years ago, the influential Kauffman Foundation raised alarms about how ETFs had tail-wagging-the-dog potential that posed a threat to the financial-market stability on days of massive asset flows.

"There were so many naysayers of the ETF vehicle, and reports on systemic risk—all of which were based on thoroughly misguided analysis," Mordy recalled. "But now that investors are more educated, we're entering what I call 'Act II,' which is about process and an exploration of the investment approaches using the ETF vehicle."

"We're moving from traditional asset classes to things like risk-factor analysis. So you might say, for example, 'my portfolio is overweight inflation,'" he said, stressing that such shifts in how to build portfolios are directly related to the emergence of the ETF. "But similar to stock pickers falling in love with a stock, we can't as asset allocators allow ourselves to get hooked on an asset class."

"The stock-picking gurus are declining in importance, and—having been on television—I find the topics of discussion are now refreshingly big picture. I don't much talk about Walmart anymore; I talk about things like what's going on in China," Mordy added.

A few episodes along the way have helped the cause of ETFs and of ETF strategists, including the mutual fund market-timing scandal of 2003, and even the financial crisis.

In the first case, the transparency of the ETF was held up as a viable way to steer clear of the opacity and shenanigans of mutual funds. A number of mutual fund firms were charged by U.S. regulators with trading after hours in and out of mutual funds on behalf of large clients to help themselves at the expense of smaller, long-term clients.

Also, in the aftermath of the 2008-2009 market crash, the low costs of ETFs relative to mutual funds and hedge funds have become clearer and much more attractive to investors shaken by two bear markets in the first decade of the 21st century.


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."


The "Special Opportunities" portfolio from Toronto-based Hahn Investment Stewards reflects the all-ETFs firm's broad top-down macro approach to the investment markets that's central to what ETF strategists seek to deliver.

The broad-as-possible diversification gives investors access to a multi-asset-class approach to global tactical asset allocation by slicing and dicing exposure by region and even particular countries. Apart from asset classes, the portfolio is also diversified across global risk factors. It's designed for a five- to seven-year holding period, during which it's meant to deliver growth and, as the relatively large position in cash equivalents clearly shows, protection against downside risk.

Among the 30 individual ETFs included in the mix are the EGShares Emerging Markets Consumer ETF (ECON | C-41), the large-cap iShares Global 100 ETF (IOO | B-83), the single-country iShares MSCI Turkey ETF (TUR | B-99), the Market Vectors Mortgage REIT Income ETF (MORT | B-93) and the PowerShares Chinese Yuan Dim Sum Bond Portfolio (DSUM | B).

The approach exemplifies what Tyler Mordy, the firm's president and co-CIO, describes as his role as an "insecurity analyst," effectively helping investors play offense by playing thorough defense that canvasses the planet's entire investable universe.

The Special Opportunities strategy had a year-to-date return of 6.07% as of May 12, 2014.

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