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Mutual Funds vs. ETFs: Which Is Better for Alpha?

Successful active management is hard to come by and the discovery is only made harder by looking for it in the wrong wrapper.

Alpha’s not easy to come by. Nor should it be. Once the exclusive purview of mutual funds, alpha is nowadays sought by exchange traded funds as well. Not too many, mind you. Of more than 2,200 ETFs, only 273 are deemed actively managed. That ought to make short work searching for alpha.

And, indeed, the list is short. According to Morningstar, only 54 active ETFs—some 20 percent of the bunch—produced positive alpha over the past 3 years. The five best delivered a 14.97 weighted-average alpha coefficient versus the S&P 500. That’s pretty impressive. But how does that stack up against the alpha earned by actively managed mutual funds?

When we set out to answer that question, we found it necessary to put mutual funds, as much as possible, on the same footing as exchange traded funds. We screened the galaxy of over 25,000 portfolios for ETF-like characteristics, such as being open to new investors and carrying a low minimum investment threshold. Most important, of course, was alpha positivity. Taking out the 254 portfolios classified as index funds, we whittled down the number of stars to 1,298, some 35 percent of the final field. Among these, the top five served up a weighted average 17.73 alpha factor.

All this points to the rarity of positive alpha and seems to give the edge to mutual funds when it’s found. But that’s not the end of the story; it’s worth looking at the field to see which funds delivered the greatest alpha and at what cost.

Most notably, the ETF table’s capped by three technology funds managed by New York-based ARK Investment Management LLC. The ARK Web x.0 ETF (NYSE Arca: ARKW), a portfolio capitalizing on cloud and mobile computing, and its stablemate, the ARK Innovation ETF (NYSE Arca: ARKK), a fund that exploits industrial innovation, genomics and web technology; both scored double-digit alpha coefficients. The No. 3 slot was filled by the ARK Industrial Innovation ETF (NYSE Arca: ARKQ) which focuses on technologies such as manufacturing automation, 3-D printing, electric vehicles and the like. 

While the top trio are all technology products, they exhibit diverse factor tilts. ARKK’s exposure is 100 percent growth. ARKW’s growth bent accounts for one-third of its returns; the rest is attributable to momentum. ARKQ’s profile is an amalgam of growth, momentum and volatility with momentum taking up about half the bill. 

It’s no surprise to find technology funds leading the alpha parade. As a class, tech portfolios—even passively managed funds—have outperformed the broad market for some time (see Tech Stocks Are This Year’s Big Winners). 

What’s startling is the No. 4 slot. It’s a commodity portfolio: the iShares Commodities Select Strategy ETF (Nasdaq: COMT). Why the surprise? Because commodities— at least agricultural commodities—have been trending down recently. COMT, however, is unlike other long-only commodity funds. COMT’s managers trade futures to be sure, but they also invest in commodity-related equities, such as natural resource and energy stocks: assets that are free from the distortions of contango and backwardation. Still, it’s not a portfolio for the faint of heart. More than three quarters of COMT’s factor load is volatility.

Rounding out the list is the AdvisorShares Dorsey Wright ADR ETF (NYSE Arca: AADR), a momentum-based portfolio of international stocks including developed and emerging markets. Momentum, in fact, accounts for nearly 80 percent of AADR’s factor exposure.

On the mutual fund side, the top position is taken by the Oppenheimer Global Opportunities Fund Class A (OTC: OPGIX), a portfolio that can be best described as “partly tech.” OPGIX’s managers invest in domestic and international companies developing new technologies as well as outfits engaged in aging issues, restructuring and promoting what the sponsor refers to as “mass affluence.” Factorwise, growth and volatility tilts are equally exhibited by this fund. 

The other four slots in the table are filled by full-scale technology funds. At No. 2 is the Victory RS Science and Technology Fund Class A (OTC: RSIFX), managed by means of fundamental and quantitative analysis and populated by companies exhibiting strong organic revenue growth, expanding margins, defensible competitive advantages and growing market shares. If you’re looking for a fund that capitalizes on volatility, this is the portfolio for you. More than 90 percent of its factor exposure belongs to volatility.

In the No. 3 position is the Firsthand Technology Opportunities Fund (OTC: TEFQX), which uses valuation parameters similar to those used by RSIFX to screen investment candidates. TEFQX managers have a free hand to invest globally and plumb any capitalization tier for purchase targets. In fact, their focus on emerging opportunities tends to tilt the portfolio towards small- and mid-cap companies. This fund balances its volatility tilt against a combination of growth and high momentum factors.

No. 4 is the BlackRock Technology Opportunities Fund Investor A Shares (OTC: BGSAX), another portfolio that gives its managers license to prowl the global market for any size companies. Investment targets exhibit the potential to grow rapidly as a result of developments in application software, networking equipment, IT consulting and services, internet software, computer storage and peripherals, electronic equipment and instruments, together with telecom equipment and semiconductors. BGSAX is also free to leverage its return through the use of derivatives. Like TEFQX, the BlackRock portfolio exhibits a trident of exposures: growth, momentum and volatility, but its momentum slant is the most significant.

At No. 5 is the AllianzGI Technology A Fund (OTC: RAGTX), a portfolio that tends to invest in larger tech companies. While the fund does have some constraints on foreign investments, it has wide latitude to utilize derivatives to either enhance returns or hedge certain risks. RAGTX’s factor profile is a doppelganger of the BlackRock fund.

The Final Analysis

As mentioned above, the weighted average alpha for the ETFs is 14.97 versus the 17.73 coefficient earned by the mutual funds. Why a weighted average? Because assessing a portfolio by its market weight tells you where investors are putting their money and what results as a consequence.

The mutual fund table is dominated by the $9.8 billion Oppenheimer portfolio. OPGIX takes up nearly three quarters of the table’s total assets. The fund’s relatively low 11 percent year-to-date return drags down the table’s weighted return to 15.69 percent. Because the ETF assets aren’t as concentrated, the exchange-traded weighted return is nearly half again higher at 22.55 percent.

With these figures in mind, we can now determine the cost efficiency of the funds in delivering this year’s return and the longer-term alpha. The weighted average expense ratio for the ETFs is 70 basis points; for the mutual funds, it’s 127 bps. Dividing the weighted returns and alphas by each table’s weighted expense ratio gives us efficiency factors that can be directly compared. Here, higher factor values denote greater efficiency and are more desirable.

The numbers speak for themselves. ETF investors have committed the bulk of their assets to the most efficient portfolios while mutual fund investors have sunk their money in less able products.

Yes, alpha’s hard to come by, but this analysis tells us its discovery is only made harder by looking for it in the wrong wrappers.

Brad Zigler is WealthManagement's Alternative Investments Editor. Previously, he was the head of Marketing, Research and Education for the Pacific Exchange's (now NYSE Arca) option market and the iShares complex of exchange traded funds.

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