Ever since the first index-tracking fund was launched the early 1970s, investment pundits have been throwing brickbats at each as they debate the merits and the costs of active management. You know the argument. It basically boils down to this: “Does active management pay for itself?” More precisely, “After trading costs and management fees, is alpha actually earned?”
The debate’s raged for four decades, centered mostly on institutional portfolios and mutual funds. A new wrinkle was added in 2008 when actively traded exchange-traded funds debuted.There are just a handful of actively managed ETFs available now, though a truckload are in registration limbo. Some of the largest fund managers, including Pimco, Eaton Vance, BlackRock, State Street and even Vanguard, have all tossed their hats, and their requests for exemptive relief, into the ring.
It hasn’t been easy for actively managed ETFs to gain traction. By last count, the 32 portfolios that can actually claim the “active” tag (more on this later) held $4.3 billion in assets. Dash the thought the average fund holds $135 million; only eight have actually amassed more than $100 million.
Up until now, active management in the ETF space has been mostly a niche market. That may soon change as the big fund players try to reach alpha-seeking investors and advisors.
Five fund companies currently own the actively managed ETF market:
Wisdom Tree Investments
The largest block of active ETF assets -- $2.8 billion -- is managed by Wisdom Tree Investments. The company’s nine currency portfolios are designed to produce money market income streams while higher yields are sought by two local debt funds concentrating on emerging and Asian markets.
More than third of Wisdom Tree’s active assets are invested in its Emerging Markets Local Debt Fund (NYSE Arca: ELD), which holds paper issued by more than a dozen Asian, Latin American and EMEA nations. At last look, ELD’s yield to maturity was 5.64 percent, which goes a long way in explaining its relative popularity.
Wisdom Tree ETFs
Wisdom Tree also runs a self-advertised “managed futures” fund which, in fact, tracks the Diversified Trends Indicator, a rules-based long-short index. The $95.6 million Wisdom Tree Managed Futures Strategy Fund (NYSE Arca: WDTI) was launched in January 2011 and is managed at an annual cost of 95 basis points.
What Wisdom Tree is to international fixed income, PIMCO is to domestic debt. PIMCO’s four actively managed portfolios have garnered more than a billion dollars in assets since its premier PIMCO Enhanced Short Maturity Strategy Fund (NYSE Arca: MINT) was launched in November 2009.
MINT accounts for 86 percent of PIMCO’s active ETF assets and seeks to generate greater income and total return than money market funds. Most recently, the MINT portfolio’s yield to maturity was clocked at 1.52 percent with an effective maturity of just over 11 months.
For most asset management firms, actively managed ETFs are an add-on to their existing product lines. Not AdvisorShares, though. The Maryland-based firm offers nothing but actively managed ETFs and is now the third-largest in assets under management.
There’s a price for such specialization, though. The weighted average expense ratio for AdvisorShares’ six operational funds is 123 basis points, not far from the average cost of similar mutual funds.
The Cambria Global Tactical ETF (NYSE Arca: GTAA) accounts for nearly 60 percent of AdvisorShares’ assets. GTAA is a momentum-following fund-of-funds using multiple asset classes. The fund will either be fully invested in an allocation or will defensively go to cash when momentum reverses from upside to downside.
With just one actively managed portfolio presently, iShares is in fourth place. The Diversified Alternative Trust (NYSE Arca: ALT) trades currency forwards and financial futures, attempting to generate absolute returns with little volatility and low correlations to equity and bond markets.
Invesco PowerShares Capital Management
With five ETFs and $79.8 million in assets, PowerShares takes the fifth seat at the table. Paradoxically, the PowerShares portfolios are some of the longest-lived fund extant, yet are also the smallest, averaging just $11 million each.
The PowerShares flagship is the Active AlphaQ Fund (NYSE Arca: PQY) which attempts to outperform the Nasdaq 100 by carving out a relatively small portfolio of issues exhibiting the strongest earning growth, the lowest valuations and most positive money flows.
Some ETFs are marketed as actively managed when they are, in fact, index trackers. The confusion is usually attributable to the abstruse nature or novelty of the underlying index. Take, for example, Wisdom Tree’s Managed Futures Strategy Fund mentioned above. The fund mechanistically follows the Diversified Trend Indicator which divvies up the commodities market by segments, then flips the switch between short and long positions for each, depending upon a commodity’s momentum above or below its moving average.
ProShares offers two alpha-seeking ETFs. One, the Credit Suisse 130/30 Fund (NYSE Arca: CSM) that actually manages an index around the margins. CSM seeks to maintain a market beta (1.00) through leveraged long and short positions from the index roster. The more recently introduced RAFI Long/Short Fund (NYSE: RALS), by index methodology, takes long positions in stocks with strong fundamentals that market-capitalization benchmarks may have underweighted and sells short issues with poor fundamentals that may be overweighted.
By far, however, the largest number of look-alike funds comes from the First Trust family of AlphaDEX trackers. Fully 29 portfolios, with assets totaling more than $3.1 billion, use the methodology. AlphaDEX is really an index enhancer that culls broad-based, style and sector benchmarks of issues with poor fundamentals, then overweights the remaining stocks with the best growth factors. All this for an average expense ratio of 70 basis points.
Can Alpha Be Earned in an ETF?
In a word, maybe. It’s as hard to produce alpha in an ETF as it is in a mutual fund. Maybe harder, for reasons to be explained a bit later. The short track record of the actively managed ETF universe makes meaningful analysis difficult. Analytical firms usually wait until a fund marks its third anniversary to post its portfolio stats. With this in mind, we’ll compare the track record of one of the longest lived ETFs -- the PowerShares Active AlphaQ -- with the investable version of its Nasdaq 100 benchmark, the PowerShares QQQ (Nasdaq: QQQ).
First, and most apparent, is the difference in the funds’ compound returns. PQY clearly lagged QQQ for the past three years -- most particularly on market upswings. PQY’s relatively low r2 coefficient, too, indicates how grossly AER Advisors, subadvisors to the fund, rejiggered the portfolio away from the benchmark construction. Pure and simple, there was only negative alpha to be earned here.
Does Active Management Pay for Itself?
That’s not say that alpha can’t be earned. After all, we’re only looking at one fund. Ask any manager in the space, though, and you’ll be told that the relative transparency of actively managed ETFs makes alpha generation harder than in the mutual fund format. Under current rules, actively-managed ETFs must provide daily disclosure of their holdings, albeit with a one-day lag. That makes it hard to thwart reverse engineering and front-running. Any alpha that could be earned can literally be stolen.
The recent development of “NAV-based trading,” a patented technology now owned by Eaton Vance and under review by the SEC, could allow managers to better hide their portfolios from prying eyes. With NAV-based trading, investors would only see a so-called “proxy price,” not the actual indicative intra-day value of a fund. The proxy price represents a fixed spread from the fund’s end-of-day NAV at which a fund order could be executed at the market close.
Once there’s a way for managers to better protect their intellectual property, the more likely they are to bring products to the ETF space. That means more choices for investors and advisors alike.