The truth about ETF outperformance is that alpha is hard to come by … and that is a good thing for most investors.
A recent post by Paul Britt of ETF.com talked about how only 15 of 425 U.S. equity strategies have beaten their benchmarks over the past 52 weeks. The article points out that the universe of ETFs they compared were judged according to a similar benchmark, and only funds with a statistically significant level of alpha were included on the winners list.
However, that statistic may be somewhat misleading, as the majority of ETFs are designed to track a passive index and are therefore going to provide returns (less fees) that are measurably similar to their established basket of stocks. You should actually take comfort in the fact that ETFs are not significantly straying — either positively or negatively — from their constituent index, because that means they are functioning correctly.
The majority of investors who use ETFs prefer them because they provide a level of exposure to a specific segment of the market with minimal embedded expenses. Their growth is continuing to outpace actively managed mutual funds because they deliver a transparent, flexible, diversified investment vehicle that performs as advertised.
While active management can provide a measure of alpha during favorable periods, many studies have confirmed that the majority of active portfolio managers can’t demonstrably and repeatedly outperform the market over the long term. The concern of paying higher fees for weaker performance is just one reason why ETFs have continued to expand, particularly among the lowest-cost providers such as Vanguard and Charles Schwab.
Despite this stigma, active ETFs have the most potential to outperform their benchmark (i.e., add alpha) when compared to passive indices. There are currently only 18 U.S.-focused equity ETFs with an “active” designation according to SEC regulations. That excludes smart-beta and other enhanced indices that can modify their holdings on a regular basis but are still considered passive vehicles.
In addition, only four on that short list have accumulated assets in excess of $100 million; the First Trust North American Energy Infrastructure (EMLP) is the largest of the group with $780 million. Investors just haven’t embraced these active funds the way many providers expected.
However, that doesn’t mean that alpha-seeking ETF strategies are going to languish by the wayside. In fact, I expect this area to grow significantly over the coming years as many established mutual fund brands make the leap to an ETF vehicle.
MFS recently teamed up with State Street to launch a suite of three actively managed ETFs that follow growth, value and core strategies. In addition, popular fund company Calamos Investments just released the Calamos Focus Growth ETF (CFGE), which is designed to be a crossover from its popular Calamos Focus Growth Mutual Fund (CBCAX). This stock-picking strategy is designed to select blue-chip equities that the fund manager believes offer the best value opportunity for sustainable growth.
That research and expertise does come at a cost. CFGE charges a net expense ratio of 0.90%, while the SPDR MFS ETFs have expense ratios listed at 0.60%. That’s a fair sight larger than the 0.05% expense ratio of the Vanguard S&P 500 ETF (VOO), which is one of the primary benchmarks for CFGE.
Often these active ETFs will employ a smaller selection methodology to hone in on the stocks that they believe will provide the best risk-adjusted returns to outperform their benchmark. Investors will have to decide for themselves whether the added fees and proprietary portfolio mix will be enough of an enticement to choose an active ETF over a commensurate passive benchmark.
Whatever choice you make, ensure that you are carefully weighing the pros and cons for each investment opportunity as it relates to your risk tolerance, time horizon, and objectives.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. As of this writing, he had no positions in the securities mentioned. To get more investor insights from FMD Capital, visit their blog.