There's been a lot of ballyhoo in recent months over the growing number of actively managed exchange-traded funds (ETFs) that have come to market. The conventional wisdom among financial advisers is that investors should deploy their money using methods that remove emotion from the equation, such as sticking to passive index strategies. Lately. however, some market strategists are saying the wild fluctuations of the current equity environment call for a more active approach to investing, an alternative to sitting idly and watching your retirement nest egg shrivel.
But that flies in the face of volumes of research that have shown 80% of active fund managers underperform the benchmark their funds track.
The allure of ETFs that track an index is that people who don't have a lot of money to put into an array of strategies can buy a stake in a diversified basket of stocks that can be traded easily at a very low cost, The problem with passively managed index funds, as most active ETF managers see it, is that the indexes weight stocks based on their market capitalization rather than on fundamental factors such as earnings growth, cash flow, and value. The index funds thus give greater weight to stocks with higher price-earnings ratios and less weight to undervalued stocks, which makes most indexes vulnerable to sudden market corrections.
PASSIVE STRATEGY
There's no consensus on what constitutes active management for ETFs. The U.S. Securities & Exchange Commission, in a March 2008 rule proposal, defined it only as not seeking to track the return of a particular index and instead selecting "securities that are consistent with the ETF's investment objectives and policies." Some financial advisers believe that, as long as a fund applies a model consistently and doesn't change its quantitative strategy according to what the market does, it qualifies as a passive strategy, even if generates higher returns than the benchmark index,
For SPA ETFs, a specialist provider of ETFs based in New York and London, active management means using a rules-based quantitative methodology to analyze and rank 5,400 U.S.-listed companies and to pick stocks for six different portfolios based on 24 factors that focus on potential for earnings growth and low valuations. Among the filters that ensure greater diversity for SPA's MarketGrader 40, 100, and 200 ETFs—which comprise the top-ranking 40, 100, and 200 stocks, respectively—are quotas that limit large- and small-cap stocks to 25% of the portfolio each and mid-caps to 50%. No more than 30% of the holdings can be in any one industry, such as energy, and no more than 15% can be in any one sector within an industry, such as oil producers. Three additional Market Grader ETFs are geared to stocks with large, medium, and small market caps.
Once SPA's computer model chooses the stocks, they are all weighted equally so they have an equal opportunity to outperform. The MarketGrader 40 is rebalanced every quarter by using profits from paring top gainers to beef up on shares of the worst performers and replacing only those stocks that fall below the required ranking. The other five portfoios are rebalanced every six months.
LONG-TERM FOCUS
The advantage of choosing stocks according to a rules-based quantitative model is that the model picks the holdings with no human intervention, taking emotion out of the process, says Daniel Freedman, managing director of SPA. However flawed you may think the rules are at any given time, the system forces you to focus on the long-term picture, he says.
"The question is, do you have the [nerve] to top up the companies you see not performing in a way you want them to?" he says. "For a company that has underperformed, eventually the underperformance would be seen by the system and it would be chucked out." The turnover rate is 40% to 60% every time the portfolios are rebalanced, he adds.