Looking for a performance kick from actively-managed ETFs

When investors think of ETFs, it is typically as passive index funds where low cost and broad diversification are main selling points. This is due in part to the large number of passive products available and why the “ETF vs. mutual fund” debate is often framed as a question of active versus passive management. Actively managed ETFs become lost in the conversation. But this can be a serious oversight for investors seeking some additional performance kick from their ETF allocations, as the combination of low cost structure and successful active management can result in some of the best-performing fund products in the market today.

Asking the right question

The most important question for any actively managed fund is whether the performance justifies the higher fees paid by the investor. Although seemingly difficult at first, Active Share analysis, developed by professor Martijn Cremers of the University of Notre Dame, provides a simple and elegant way to find the answer.

It begins by calculating the Active Share, which subtracts overlapping positions in the actively-managed fund from its benchmark index (represented by an index ETF). This gives the percentage of the fund that is different from the index, which should be at least 40% to qualify as actively managed.

Next, a similar process isolates the Active MER by restating the MER in terms of the Active Share. The resulting value represents the effective fee paid by the investor for the actively-managed part of the portfolio. Subtracting the index MER from the Active MER leaves the Hurdle Rate, that is, the minimum return over the index that the fund must earn to justify its fees. If the annual excess return over the index is higher than the Hurdle Rate, then the fund earned more than the cost of active management.

The accompanying table presents these values for three top-performing actively managed ETFs through the year ended July 31, 2018. Dynamic iShares Active Canadian Dividend ETF (TSX: DXC) in the Canadian Equity category, Horizons Active Cdn Bond ETF (TSX: HAD) in Canadian Fixed Income, and Dynamic iShares Active Global Dividend ETF (TSX: DXG) in Global Equity.

One of the keys to success in active management is a balance between fees and performance. Good managers command higher fees, but fees that are too high form a significant negative drag on performance. These three ETFs earn comparatively high returns on their own, but a low fee structure is equally important to their performance. Although the MERs of the ETFs are twice that of their respective indexes or higher, they are still at least 50% less than their top-performing mutual fund counterparts. The result in each case is an excess return that easily overcomes the Hurdle Rate.

Dynamic iShares Active Global Dividend ETF (DXG) is noteworthy in particular, as it sails over its Hurdle Rate with a blistering one-year return of 29%, an Excess Return of 13 percentage points over its benchmark. It achieves this return through skillful stock selection, specifically focusing on large-cap companies with growing yields. The fund actually targets a high Active Share in order to differentiate the portfolio from its benchmark and lists that as one of the main reasons to invest. At an extremely high 94%, the calculated Active Share validates the claim. While that alone does not imply better performance, it does show that the manager knows what it takes to deliver truly valuable active management.

Dynamic iShares Active Canadian Dividend ETF (DXC) targets dividend-paying companies with attractive values and quality management teams. This fund has the lowest Active Share of the three, at 62%, which may in part be a reflection of a more limited investment universe. Regardless, the performance of this fund positions it as a cost-effective, actively-managed dividend fund with one of the highest one-year returns in the category.

Finally with a return of 3.6%, Horizons Active Cdn Bond ETF (HAD) is the top Canadian Fixed Income fund over a one-year period, beating both ETFs and mutual funds. At 88%, the high Active Share of this fund seems to be a result of sub-advisor Fiera Capital Corp.’s careful management of individual bond holdings rather than a specific target. Active monitoring of interest rates and durations of fixed-income constituents is crucial when interest rates are changing, and this type of investment environment benefits especially from an experienced manager.

The sky’s the limit

From an investor standpoint, ETFs suit active management just as well, if not better than, passive management. Actively-managed ETFs may be generally less well known than their wildly popular passive peers, but an increase in the variety of recent launches may signal a possible shift in this balance. ETF providers will very probably continue to deliver quality active management within a highly competitive ETF fee structure. Investors should consult with their advisors to consider what role these funds might play in their portfolios.

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