Forget active: savvy investors are going for the smart ETFs instead

WHEN BlackRock acquired Barclays Global Investors and its exchange-traded funds (ETFs) business iShares back in June in a multi-billion dollar deal, it was widely expected that this would give some impetus to the evolution of ETFs both in the US and in the UK.<br /><br />One product that was expected to arrive in the UK was the active ETF, which had already existed in the US since March 2008. Active ETFs &ndash; at least in their initial form &ndash; were designed to take the structural simplicity of a passive ETF (which simply replicates an index&rsquo;s performance over time), and add to this the benefits of a mutual fund or unit trust such as a professional management and stock selection. <br /><br />In theory, this ought to increase the returns as the managers should have omitted those stocks which were expected to underperform and build up stakes in those forecast to do well. <br /><br />At the end of the third quarter of this year, just seven ETFs out of the 721 listed in the US were active ETFs, according to figures from Barclays Global Investors, amounting to just $50m of assets under management. <br /><br />Yet while they sound in theory like the perfect instrument and have attracted some interest in the US where the ETF market is more mature, active ETFs have not yet made their way across the pond. Obviously, the financial crisis has slowed the development of new products &ndash; Bear Stearns launched the first active ETF six months before its demise &ndash; and providers have preferred to concentrate on taking their existing products to new markets.<br /><br /><strong>FUNDAMENTAL SCEPTICISM</strong><br />But there is more to it than that. In fact, there seems to be fundamental scepticism on this side of the Atlantic about active ETFs. Tim Mitchell, head of listed fund sales at Invesco Perpetual, argues that the whole idea of an active ETF is &ldquo;like trying to put a square peg in a round hole&rdquo;. <br /><br />Active management was designed to work within investment trusts or open-ended fund structures, he says, and active ETFs inevitably lose some of the benefits that their passive counterparts offered investors in the first place, such as transparency, simplicity and low cost. <br /><br />For example, all ETFs announce their constituents on a daily basis but fund managers (or those running active ETFs) may not want to disclose their positions in case people try to trade against them. <br /><br />What&rsquo;s more, as an investor in an active ETF you would be trading at a time lag to the fund manager which means that your holdings will never trade at what the fund manager considers to be the optimal price and you will therefore lose at least a few basis points on each trade. <br /><br />Equally importantly for investors looking at potential returns, passive ETFs can be back tested to see how they would have performed. But as soon as you add an active element to an ETF, back testing is no longer possible because the performance of the active ETF will depend on stock selection &ndash; the first day of operation marks the point at which the record begins. <br /><br />In fact active ETFs are not necessarily as good as they sound. Although over the past year, Invesco Powershares&rsquo; active alpha multi cap fund &ndash; which rates the stocks of companies with more than $400m market cap and then selects stocks to trade &ndash; has risen 23.6 per cent, the same provider&rsquo;s passive ETF based on the Russell 1000 is up nearly 40 per cent over the same period.<br /><br />But while active ETFs might be off the table in Europe, at least for now, investors could look to use passive ETFs in an active manner within their portfolio. Manooj Mistry, head of DB x-trackers ETFs in the UK, says that there is scope for passive ETFs to work alongside active management in a core-satellite model of structuring a portfolio. <br /><br />That is, the core of your portfolio is static while the satellite is for your tactical asset allocation. ETFs can work equally well in both the core and the satellite &ndash; you can use them to provide beta and combine with funds or stock picking that will generate your portfolio&rsquo;s alpha, says Mistry. <br /><br />In its original form, beta reflects the relative volatility of a stock compared to the market as a whole. In terms of ETFs it signifies just how closely the ETF moves in line with the underlying market index. Most passive ETFs aim for a beta of one &ndash; that is, tracking the selected underlying index perfectly. <br /><br />In contrast, alpha is a measure of performance in percentage above or below what would have been predicted by risk as suggested by its beta. Active ETFs aim to generate positive alpha and outperform the underlying rather than simply track it. <br /><br /><strong>ENHANCED BETA</strong><br />He says that as much as 80 per cent of a portfolio&rsquo;s returns are generated from the right asset allocation, while the rest is a bit of luck and good timing. The diversity of passive ETFs on offer means that they can certainly help you tailor your portfolio to your precise wants &ndash; that is, actively select which passive ETFs go into your portfolio. <br /><br />For ETF Securities&rsquo; co-head of European sales Scott Thompson, enhanced beta indices could be the way forward. For example, an ETF will track an index, but two or three of the index&rsquo;s constituents might be omitted because they have had several broker warnings and so their performance is not forecast to be as good as others. <br /><br />For example, iShares offers exposure to around 50 UK companies with the highest forecast dividend yields in the FTSE 350 with its FTSE UK Dividend Plus ETFs. This should in theory help the ETF to outperform the general index, because the elements dragging down the underlying asset will not be reflected in the performance of the ETF. <br /><br />While the UK and European ETF market typically looks to the much larger, more advanced US market for any future product development, active ETFs look unlikely to create enough of an impression for them to appear over here. As Invesco Perpetual&rsquo;s Tim Mitchell puts it, &ldquo;There are plenty of people out there who do active management really well. Rather than trying and reinvent the wheel, let&rsquo;s just do passive better.&rdquo;<br />