Active management conjures the image of a fund manager and team of analysts pouring over fund reports, charts, and press releases as they try to select the right stocks to meet their mandates. But increasingly, old-school stock or bond picking is becoming a thing of the past. Active management and active ETFs mean something else entirely.
Welcome to the world of enhanced active strategies.
Enhanced active strategies have taken the investment management world by storm; today, the vast bulk of the biggest active ETFs use the technique to beat their benchmarks and generate additional alpha for portfolios. While some investors may feel cheated by these index-plus strategies, the reality is they can do a lot for your portfolios over the long haul.
Active But Not Traditionally Active
Active ETFs have taken the world by storm in recent years as changes to SEC rules have driven growth. But for many investors, that active proposition represents traditional stock or bond picking. The truth is many of the most popular active ETFs aren’t stock picking in the traditional sense.
Many active ETFs now fall under the heading of enhanced active strategies, sometimes called enhanced indexing or systematic equity. Here, managers will take an index and apply small active massages to the benchmark. This can include applying value screens, looking for strong balance sheets, or scoring momentum and dividend yields. Managers use these systematic elements to purchase stocks or bonds to tweak an index.
This is not to be confused with smart-beta, for which managers build a screen based on their criteria and then create an index of assets matching those criteria. Smart-beta becomes a passive approach after designing the screen, where enhanced equity strategies are still very much an active choice, with managers buying/selling within their framework.
The key to building and maintaining enhanced active portfolios comes down to the rise of analytics, data mining, and more advanced technology to exploit various factors and triggers to build portfolios of equities that deliver excess returns. Artificial intelligence (A.I.) is now quickly becoming a game changer for enhanced portfolios as active managers can react to signals much faster or even ahead of time.
The Benefits of Enhanced Active
The question probably going through your mind is, “What’s the point?” Why even bother? Passive investing and true indexing can provide plenty of cheap beta exposure, particularly at scale. So why mess with enhanced active or systematic equity strategies?
The answer is better and more consistent outperformance.
The whole point of going active in the first place is to generate additional alpha or excess return over a benchmark. Doing that in a consistent manner is very tough when you are traditionally stock picking. Performance for traditional stock picking tends to be boom or bust. The beauty of passive and index investing is volatility tends to be reduced and outcomes are more predictable. But what you see is what you get, good and bad.
Enhanced strategies seek to deliver on both fronts. While being benchmark aware, managers can deliver steady index-like beta to a portfolio with a consistent extra boost to performance. It’s the focus on consistency of positive performance rather than magnitude that helps enhanced active strategies work. The proof is in the potential for excess returns.
This chart from Goldman Sachs shows enhanced active strategies with low track errors to a broader benchmark can generate a higher probability of excess returns.
Source: Goldman Sachs
By staying close to the index and slightly tweaking it to stay within its desired risk target, enhanced active strategies can consistently outperform by a few basis points year in and year out. While that may not seem like much, small differences in performance over the long term add up. Compounding allows an enhanced strategy to outperform indexing and traditional active over the long term.
Meanwhile, by hugging the index and staying close, the dispersion of returns and volatility is reduced. This helps eliminate volatility decay and swings within a portfolio, again boosting long-term market-beating returns.
For example, the Dimensional U.S. Core Equity 2 ETF is an enhanced equity strategy based on the Russell 3000 index and holds over 2,600 stocks. The ETF’s returns have been significantly correlated to the index, but has managed to outperform it by a slight amount and it’s done so with lower volatility.
Enhanced Active ETFs for Your Portfolio
All in all, enhanced active strategies can make a real difference in helping generate market-beating and stable returns, with the ETF structure remaining a great way for enhanced active to thrive.
The easy answer remains that ETFs lower costs. After all, if the goal is to outperform by just a few basis points per year, then lower costs allow investors to capture more of that return. Second, because they are not passive strategies, there is some trading that goes into enhancing active ETFs. By using an ETF, managers can push capital gains out toward the authorized participants (APs) and help reduce taxes.
All in all, enhanced active ETFs are proving a little active management can go a long way to producing benchmark-beating returns. Some units have suggested using them as the building blocks for a core portfolio, while others have suggested adding them to an index fund. That decision is a personal one. Either way, enhanced active strategies could be a great way to boost the performance of any portfolio.
Enhanced Active ETFs
These ETFs provide exposure to enhanced or fundamental strategies with an active touch. They are sorted by their YTD total return, which ranges from -0.4% to 6.2%. They have expense ratios between 0.17% and 0.28% and assets under management between $3.3B and $21B. They are currently yielding between 0.4% and 1.5%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| DFUV | Dimensional US Marketwide Value ETF | $8.5B | 6.2% | 1.5% | 0.21% | ETF | Yes |
| DFAC | Dimensional U.S. Core Equity 2 ETF | $20.9B | 5.7% | 0.8% | 0.17% | ETF | Yes |
| FELC | Fidelity Enhanced Large Cap Core ETF | $4.5B | 3.3% | 1.04% | 0.19% | ETF | Yes |
| FELG | Fidelity Enhanced Large Cap Growth ETF | $3.3B | 2.4% | 0.46% | 0.19% | ETF | Yes |
| AVUV | Avantis U.S. Small-Cap Value ETF | $6.7B | 0.80% | 1.4% | 0.25% | ETF | Yes |
| DFAT | Dimensional U.S. Targeted Value ETF | $8.2B | -0.4% | 0.8% | 0.28% | ETF | Yes |
As active ETFs have grown, enhanced active strategies are now quickly becoming a part of the equation. Offering better and more consistent market-beating returns, these ETFs can truly deliver both active and passive benefits, all while maintaining a low cost profile. For investors, that’s huge news for their portfolios and ability to generate great long-term returns. Using them in your portfolio makes a ton of sense either as a core position or complement for a core portfolio.
The Bottom Line
As active ETFs have grown, so have enhanced active or indexing strategies. By using data capabilities, these funds provide active management with index-hugging low volatility. That’s a net win for investors looking for steady returns.
