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The Line Between Active and Index Is Blurring

With non-cap weighted indexes and manager-driven qualitative approaches increasingly found in ETF wrappers, the line between purely passive and active management is getting cloudier. The subject is up for discussion at the upcoming Inside Smart Beta & Active ETF Summit. Here’s a preview.

The distinction between active and passive investment management is increasingly blurry as firms with long histories in active management broaden their exchange traded fund product offerings. CFRA Research compares equity ETFs against each other regardless of whether their approach is market-cap weighted, smart-beta or actively managed, but we think investors need to understand what makes each unique.

CFRA will be talking about this very issue on two panels at the upcoming Inside Smart Beta & Active ETF Summit in New York on June 6 and 7. Indeed, the expansion of this conference beyond just a focus on smart beta is confirmation that there are sufficient actively managed ETF products to discuss and that further education is warranted.

SPDR S&P 500 (SPY) is the oldest and largest ETF around and it tracks a benchmark that is widely used as a reference point for U.S. active and passive funds. While there are now many smart-beta iterations of this index constructed based on value, dividends or quality traits, SPY is market-cap weighted. As such, Apple, Microsoft, Amazon and Facebook are the largest holdings as these are the most valuable public companies in the U.S.

SPY is managed passively, but it incurred a 3 percent annual turnover rate as the index is reconstituted periodically and without warning. Deletions occur, for example, when constituents merge or a member is deemed no longer representative of large-cap stocks in the eyes of the S&P Dow Jones Indices. However, the hefty 23 percent and 14 percent weightings in technology and financial stocks, respectively, and the modest 3 percent stakes in real estate and utilities are all likely to stay consistent when investors review the ETF a year from now.

Meanwhile PowerShares S&P 500 Low Volatility (SPLV) is an example of smart-beta ETFs, which are, in essence, all non-market-cap-weighted index ETFs. SPLV holds the 100 constituents of the S&P 500 index with the lowest volatility and is reconstituted quarterly. SPLV recently had a 49 percent turnover rate. Investors might use SPLV to reduce the risk profile of their large-cap exposure and to have transparency into the volatility of the market in real time.

For example, the index behind SPLV increased its exposure to utilities to 25 percent on May 18, from 23 percent three months earlier. Real estate jumped to 13 percent, from 8 percent. In contrast, financial and industrials sector exposure decreased by 400 basis points to 16 percent and 12 percent, respectively. Meanwhile, technology exposure was trimmed to 9 percent, from 10 percent. But PowerShares’ implementation of the changes in the fund has been the result of passively tracking the S&P Index, not an active approach based on management’s decisions.

Yet investors need to understand not all ETFs with low volatility in the name will have the same sector exposure. Index-based ETFs Fidelity Low Volatility Factor (FDLO) and Oppenheimer Russell 1000 Low Volatility Factor (OVOL) came to market in 2016 and 2017, respectively. FDLO has 25 percent of assets in technology, while OVOL has 22 percent.  

Meanwhile, Vanguard launched actively managed ETFs in February 2018. Vanguard U.S. Minimum Volatility ETF (VFMV) and its siblings also follow rules-based approaches to evaluating stocks. Yet while VFMV focuses on stocks generating lower volatility than the broader market, implementation of the strategy is an active and not a fully transparent one. Vanguard’s quantitative equity group doesn’t have a set schedule of reconstitution like SPLV and others. Indeed, the current sector exposure is largely unchanged since the fund launched with financials (20 percent of assets) the largest of the sectors, according to Bloomberg data.

Vanguard’s new equity ETFs are more consistent with the systematic, quantitative approach that remains popular in mutual fund wrappers offered by Vanguard, Fidelity and other firms. Fidelity Large Cap Value Enhanced Index Fund (FLVEX) and Vanguard Strategic Equity Fund (VSEQX) are good examples of these strategies in mutual funds.

However, there are increasingly active equity ETFs to consider that are versions of these qualitatively constructed strategies. Such ETFs are constructed based on evaluations made by fundamentally focused managers.

Davis Advisors now offers four equity ETFs that are analogs of pre-existing mutual funds strategies. For example, Davis Select US Equity ETF (DUSA) has its origins in the Clipper Fund (CFIMX) that Chris Davis and Danton Goei have run for more than a decade. DUSA came to market in early 2017 and holds 22 stocks. The ETF gets a lower ranking from CFRA than the mutual fund in part due to the ETF’s high expense ratio (as opposed to the mutual fund’s below-average expense ratio).

Amazon and United Technologies are examples of holdings chosen by Davis and Goei to be in the portfolio because fund management thinks the companies are global leaders selling at appealing prices. Relative to SPY, DUSA is significantly overweighted to financials and underweighted to technology. This is a conscious decision. Despite its active approach, DUSA’s low 6 percent turnover rate is closer to SPY than the index-based SPLV. Yet, management could choose to pare back its stake at Amazon without warning.

Relative to market-cap weighted ETFs, like SPY, smart-beta and actively managed ETFs tend to incur higher costs. Of course, fees vary. OVOL’s 0.19 percent net expense ratio is lower than the 0.25 percent and 0.29 percent for SPLV and FDLO, respectively.


Todd Rosenbluth is the director of ETF and mutual fund research at CFRA. Learn more about CFRA's ETF research here

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