Financial advisors who believe that indexing always wins over actively managed portfolios may want to re-think that belief. And the outperformance of certain actively managed ETFs is enough proof.
Actively managed funds like the ARK Innovation ETF (ARKK) and ARK Next Generation Internet ETF (ARKW), for instance, have trounced popular index funds such as the Invesco QQQ ETF (QQQ), which tracks the Nasdaq-100 Index, and the Vanguard S&P 500 ETF (VOO), which is linked to the S&P 500 Index. During the past five years, ARKK and ARKW have soared with total returns of 378.7% and 458%, respectively, versus gains of 164.5% for QQQ and 84.3% for VOO.
The outperformance of active funds like ARKK and ARKW runs counter to current ETF trends. Moreover, it has occurred during a climate when index-linked ETFs have dominated in both asset flows and performance.
The latest Morningstar Active/Passive Barometer, which was released in August, stated that “actively managed funds (including ETFs) have failed to survive and beat their benchmarks, especially over longer time horizons.” The study found that only 24% of all active funds topped the average of their passive rival over the 10-year period ended in June 2020.
What should advisors look for in an active ETF? A good place to start is by gauging a fund’s “active share,” which measures how much a portfolio’s holdings differ from its benchmark index. While this metric alone doesn’t necessarily indicate manager skill or guarantee excess performance over a fund’s benchmark, it could be a precursor of future outperformance.
Online tools offered by companies such as Magnifi.com and ETF Action provide insight into how much of a fund’s portfolio differs from indexed peers. For example, just 15.6% of ARKK’s current 47 holdings are held in the Nasdaq-100 and only 11.1% are in the S&P 500. The small overlap in ARKK’s holdings versus major indexes indicates a higher level of active share. The willingness of ARKK’s managers to hold securities that are different from major indexes is bold and shows conviction. On the other hand, funds posing as “active managers” that own too many of the same securities as their peer index could be the tell-tale sign of a closet indexer.
The concept of active share was developed by two Yale University professors in 2006 to quantify the relationship between a fund’s performance and the fund manager’s willingness to own securities that are different against the benchmark. For example, an active share of 20% to 60% is considered closet indexing, whereas anything from 60% to 100% is considered truly active.
A study of active share by Fidelity Investments covering the years 1997 to 2013 concluded, “Excess return seems to increase with higher active share, but so does downside risk and dispersion of returns.” The same study found that outperformance among large-cap funds was due more to their bias toward smaller companies than the manager’s stock picking prowess.
Identifying tomorrow’s winning fund managers is difficult. And even if a manager does beat their comparable yardstick, the sustainability of that outperformance typically wanes. For that reason, many advisors still prefer to use an all-index approach to portfolio construction. But keep in mind that complementing a portfolio’s indexed foundation with active funds might deliver alpha and provide a better overall market return for clients.
In the end, indexing wins most of the time but not all of the time.
Ron DeLegge is founder and chief portfolio strategist at ETFguide, and is the author of “Habits Of The Investing Greats.”