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:
- Passive ETFs tracking a market cap weighted index or “Passive”
- Passive ETFs tracking an index with “rules-based active” or “Active-Passive”
- 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.
Lunt Capital manages strategies that rotate across various factors based on quantitative rules. The Elkhorn Lunt Low Vol/High Beta Tactical ETF (LVHB), in which Lunt Capital has an interest as the index provider, tracks the Lunt Capital U.S. Large Cap Equity Rotation Index, calculated by S&P Dow Jones Indices. This index rotates between the 100 lowest volatility stocks and the 100 highest beta stocks within the S&P 500. This index has two dynamic layers—the first layer follows rules that select the securities that qualify as “low volatility” or “high beta.” The second layer follows rules to rotate between the two factors. This is the ETF industry’s first factor rotation ETF, yet it technically qualifies as a passive ETF.
The degree of active rules within an ETF continues to expand, as shown by ETFs from Innovator ETFs and Goldman Sachs ETFs. The Innovator IBD 50 ETF (FFTY) tracks the Investors Business Daily 50 Index. FFTY incorporates both fundamental and technical rules for buying and selling the underlying securities. It also incorporates the ability to move to 50% cash. The Goldman Sachs Hedge Industry VIP ETF
(GVIP) tracks the GS Hedge Fund VIP Index, which is described as following the “fundamentally driven hedge fund managers’ ‘Very-Important-Positions,’ which appear most frequently among their top 10 long equity holdings.”
Two interesting ETFs fit in the “Active-Passive” category that offer the ability to move to cash based on very different sets of rules. The Pacer TrendPilot U.S. Large Cap ETF (PTLC) moves to 50% cash if the S&P 500 Index closes below its 200-day moving average for five consecutive days. It moves completely to cash if the 200-day moving average is lower than its value five days earlier. The WisdomTree Dynamic Long/Short U.S. ETF (DYLS) takes a fundamental approach to hedging. The long portfolio of 100 stocks is rebalanced quarterly, based on fundamental criteria. The short portfolio is a dynamic hedge of 0%, 50% or 100% using S&P 500 derivatives, and is based on growth and value factors. Most advisors and investors would not care if these ETFs are technically passive—they are used within an asset allocation for their active, tactical characteristics.
Active ETFs with discretionary portfolio management or “Active”
2017 saw tremendous growth in truly active ETFs, and we expect this growth to continue in 2018. Active ETFs provide access to talented, discretionary managers within the transparent and tax-efficient structure of an ETF. Active management offers the opportunity for diversification away from inexpensive, efficient market beta. Examples include the Ark Innovation ETF (ARKK), managed by a team of researchers and active stock pickers. The managers focus on themes in genomics, web, and industrial innovation. Davis Funds, the storied active money manager, launched a series of three active ETFs during 2017. The Davis Select Financial ETF (DNFL) provides exposure to Davis’ high conviction ideas in one of their areas of expertise. These two ETFs offer access to relatively concentrated exposure to successful active equity managers. J.P. Morgan received the 2017 award for best new active ETF for its unique and compelling Diversified Alternatives ETF (JPHF). Although it is filed as an active ETF, it uses a rules-based approach to provide exposure to equity long/short, event driven strategies, and macro-based strategies. The definition of active varies across the spectrum of active ETFs!
Concerns about the potential for rising rates, a flattening yield curve, tight credit spreads, and currency uncertainty has brought actively-managed fixed income ETFs into the spotlight. State Street has provided access to one of the bond market’s titans through three ETFs actively managed by DoubleLine. The SPDR DoubleLine Total Return Tactical ETF (TOTL) and the SPDR DoubleLine Short Duration Total Return Tactical ETF (STOT) utilize DoubleLine’s active security selection and sector positioning to provide fixed income exposure that looks very different from traditional benchmarks. First Trust has been a leader in the active ETF space, and 2017 saw the launch of the First Trust TCW Opportunistic Fixed Income ETF (FIXD). This brought TCW’s value-oriented fixed income approach to ETFs. Last, the J.P. Morgan Global Bond Opportunities ETF (JPGB) leverages the firm’s impressive global platform to bring active management to global bonds in an ETF wrapper.
While many in the industry have framed the issue as “active OR passive,” we embrace a philosophy of “active AND passive.” We believe that the “active-passive” category also plays a valuable role. Categories and definitions are less important than understanding the construction, attributes, and characteristics of each ETF, and the role it is expected to play within an asset allocation. In our view, having such a vast spectrum of ETF available makes us enthusiastic about managing portfolios in 2018, regardless of political, economic, and market conditions.
John Lunt is the President of Lunt Capital Management, a participant in the ETF Strategist Channel.