Building Portfolios in 2018: Passive, Active, and Active-Passive | ETF Trends

By John Lunt, Lunt Capital

In an investment framework dominated by mutual funds, the “active” and “passive” distinction was clear.  Passive mutual funds nearly always track a well-known, market-cap weighted index within a specific asset class.  In the case of active mutual funds, a portfolio manager uses discretion (as constrained by the fund prospectus) to buy and sell the securities in the fund.

The ETF evolution is blurring the lines between “active” and “passive” in the minds of many investors and advisors. The legal, technical distinction between a “passive” ETF and an “active” ETF is clear.  Passive ETFs track a rules-based index; active ETFs give the manager discretion.  However, the lines began to blur when many ETFs started to track rules-based indices that were far more “active” than the typical market cap weighted passive index.  These “smart beta” ETFs are not “active” in the sense that the ETF is managed with discretion, but these ETFs are active in the sense that the rules that trigger changes in the underlying ETFs change more frequently and more dramatically than market cap weighted ETFs.  We categorize these ETFs as “Active-Passive.”

This article will highlight examples of ETFs in all three categories:

  1. Passive ETFs tracking a market cap weighted index or “Passive”
  2. Passive ETFs tracking an index with “rules-based active” or “Active-Passive”
  3. Active ETFs with discretionary portfolio management or “Active”

Lunt Capital has owned in the past or currently owns every ETF mentioned in this article.  This is not a recommendation to buy or sell any ETF, and positioning may change at any time.  Past performance of any ETF is no indication of its future return.  As with any investment, there are various risks associated with ETFs that a potential investor should review prior to investment.  

Passive ETFs tracking a market cap weighted index or “Passive”

The majority of ETF assets land in this category.  It is noteworthy that capturing traditional, market cap-weighted beta has become incredibly efficient and inexpensive.  In our view, continued global growth requires meaningful allocations to international ETFs.  During Q4 2017, State Street SPDRS ETFs lowered costs on core ETFs that cover each major asset class.  This included the SPDR Portfolio Developed World ex-US ETF (SPDW) with an expense ratio of 4 basis points, and the SPDR Portfolio Emerging Markets ETF (SPEM) boasting an expense ratio of 11 basis points.  Franklin LibertyShares ETFs made a dramatic entry into country-specific ETFs, launching a suite of low-cost ETFs like the Franklin FTSE Germany ETF (FLGR) and Franklin FTSE Japan ETF (FLJP) with expense ratios of 9 basis points!

Passive ETF tracking an index with rules-based active or “Active-Passive”

While the ETFs mentioned below are technically passive because they track an index, they actively rebalance and reconstitute their indices based on varying degrees of sophisticated rules.  In the minds of most advisors and investors, these ETFs are “active” in the sense that there is strategy risk involved in holding these ETFs.  The rules these ETFs follow are attempting to offer characteristics that make them more attractive in either risk management or return enhancement.  This search for outperformance comes at a cost, as these ETFs have higher expense ratios than many passive, market cap weighted ETFs.

 The varying degrees of “rules-based active” or “Active-Passive” is striking.  One of the most popular and compelling single factor ETFs is the PowerShares S&P 500 Low Volatility ETF (SPLV). This ETF tracks the S&P 500 Low Volatility Index, which includes the 100 stocks within the S&P 500 with the lowest realized volatility over the past 12 months, rebalanced and reconstituted quarterly.  Over the course of a year, the components of this ETF may change significantly.  PowerShares offers a variety of Smart Beta, “rules-based active” ETFs with different time frames for reconstitution.  While many ETFs reconstitute quarterly, the PowerShares FTSE RAFI US 1000 ETF (PRF) reconstitutes annually.  First Trust has been a leader in offering “Active-Passive” with their AlphaDEX suite of ETFs.  For example, the First Trust Large Cap Core AlphaDEX ETF (FEX) scores stocks based on growth and value factors, reconstituted quarterly.