With assets wavering midway between the $1 million and $2 million marks, the Columbia Growth Equity Strategy Fund (NYSE Arca: RPX) is the smallest active equity ETF and is benchmarked against the S&P 500 index.
RPX was floated in October 2009.
Running The Numbers
Analysis of the funds produces some telling statistics. First of all, the weighted average of the funds' expense ratios shows the bulk of the capital invested in active equity ETFs is managed at rates similar to those charged by mutual funds. If investors pay essentially the same fees for management in the exchange-traded product space as they do in the mutual fund world, they're right to wonder what advantages the ETFs hold.
Among ETFs' pluses, there's convenience, certainly. No dealer agreements are required for the brokering of an ETF transaction, so any investment house can facilitate a trade. ETFs, too, are completely portable, so they can be moved en masse with other assets in an ACAT transfer. ETF prices, too, are transparent, and liquidity is immediate.
But what about performance? Do active ETFs actually do better than their benchmarks?
As a class, the answer is no. Six of the ten funds in our universe here can't outgun their benchmarks on a risk-adjusted basis. The bulk of the capital invested in active equity ETFs, in fact, earns 3% less per annum than the market bogey (see Figure 1).
That's not to say that there aren't market beaters. A couple of standout ETFs earn positive alpha. AADR, the WCM/BNY Mellon Focused Growth ADR ETF, notched a positive reading of 16% with barely more than half of its price movements driven by its MSCI EAFE benchmark. A quarter of the AADR portfolio is currently invested in Swiss issues, so some portion of the fund's upside can be attributed to the strength of the Swiss franc against the U.S. dollar.
While the Columbia Growth Equity Strategy Fund is small, its alpha isn't. The RPX fund checks in with an 8% coefficient and a low correlation to its S&P 500 benchmark. That coefficient/correlation combination is no accident. RPX has recently overweighted its exposure to financials-nearly doubling the S&P 500's allocation-while grossly underweighting energy issues.
The funds' R squared correlations are especially worthy of note. On average, two-thirds of active ETF price movements can be explained by the gyrations of their benchmarks. Despite the active management within the portfolios, there's some index-hugging going on. To be sure, there's variance among the funds, e.g., the PQY PowerShares Active AlphaQ Fund registers an R squared of 83% while the PowerShares Active Mega Cap Fund (PMA) clocks in at only 6%, but most of the ETF money tracks the market at around 69%.
If 69% of a fund's price action is explained by its benchmark, one could argue that the remaining 31% ought to be attributed to active management. The reality is a bit more complex. Only part of a fund's return is supplied by active management. Some comes from just being in the market.
Pricing Active Management
Investors and advisors have come to accept the notion that active management is expensive. We've seen that the weighted average expense ratio of the ten funds in our universe is 1.29%. Passive management, by comparison, is cheap. Exposure to the S&P 500 index, for example, can be obtained for just 9 basis points (0.09%). Style-tracking ETFs, such as the growth or value splits of the S&P or Russell benchmarks, charge around 20 basis points.
This leads one to ponder the actual cost for the portion of fund returns derived from stock-picking. And, more important, to wonder if investors aren't overpaying for the portion of fund returns attributable to the portfolio's benchmark. Ross M. Miller, a risk consultant and finance professor at SUNY Albany, took a novel and mathematically elegant approach to these questions in a 2005 paper, "Measuring the True Cost of Active Management by Mutual Funds."
Miller claims that the bundling of passive and active management understates a fund's true expense. He's devised a method for allocating fund expenses between active and passive management and determines the cost of active management by comparing-through the R squared correlation-an active fund's expense ratio to that of an index fund tracking the benchmark. Essentially, Miller's methodology carves out the actively managed portion of the portfolio and applies the expense ratio only to that segment.
Using Miller's technique, the weighted average expense of our ten-fund universe jumps to 2.31%, 1.8 times higher than the published rates (Figure 2). That shouldn't be surprising, given that 42.9% of the portfolios are actively managed. There are outlier funds, though, that are run more aggressively, namely the Mars Hill Global Relative Value ETF (GRV) and the PowerShares Active Mega Cap Fund (PMA), each with more than three-quarters of its returns attributable to stock picking.
The outcomes of active management differ greatly for these two funds, a fact reflected in their disparate alpha coefficients.
Pricing the funds' alpha in terms of their active expense gives you a quick way to assess the cost efficiency of each manager's style and make head-to-head comparisons.
Most of the capital managed in active ETFs is now being dinged for negative alpha. The weighted average active ratio-the quotient of a portfolio's alpha coefficient and its active expense-is negative 1.32%, clearly reflecting the performance of the category heavyweights, the Cambria Global Tactical ETF (GTAA) and the Dent Tactical ETF (DENT). Together, these two funds account for more than three-quarters of active equity ETF assets.
Four smaller funds have managed to wrest positive alpha from the current market, but at greatly varying prices. The best performer-the WCM/BNY Mellon Focused Growth ADR ETF (AADR)-racked up a 16% alpha, resulting in a 6.93 active ratio. Second best was the tiny Columbia Growth Equity Strategy Fund (RPX), which produced its 8% alpha for a cost of only 1.36%. Though RPX's alpha was just half that of AADR's, the smaller fund's active ratio was nearly equivalent, owing to its lower expense.
So what does all this mean? Well, apparently small is better in the world of active equity ETFs. At least for now. There's, of course, no guarantee that these portfolio statistics will hold in the future. It's not likely, either, that these funds are appropriate for every investor's portfolio. With the sled load of active portfolios awaiting registration, there's bound to be more choice for investors and advisors in the future. But, to paraphrase a former U.S. defense secretary, you build portfolios with the funds you have, not the funds you want to have. If you have to plug a portfolio hole with an active equity ETF now, you at least have the means to evaluate its true cost.