The image of passivity
ETFs got their image of passivity from two sources.
- Legal boilerplate in documents that underlie most ETFs usually describe the fund strategy as an attempt to match as closely as possible the performance of a particular index.
- The earliest ETFs tracked well known indexes like the S&P 500, the Dow Jones Industrial Average and the NASADQ 100. These, especially the S&P 500, are the ones usually cited by investment theorists who advocate passive investing.
Neither of these factors are critical to the existence of an ETF.
There is no inherent reason why an ETF cannot be formed on the basis of a portfolio that is actively managed. As discussed in the last blog, the essence of an ETF, relative to other kinds of funds, is exchange-tradable shares and the in-kid creation-redemption mechanism. There is no inherent reason why an ETF portfolio has to passively track anything. Its portfolio managers can be given just as much discretion as we are accustomed to seeing for other kinds of funds. And indeed, some actively-managed ETFs have already come into existence and others are in registration.
But the fact that something is possible doesn't necessarily mean it's a good idea.
The more active the portfolio manager, the greater the reporting burden regarding portfolio holdings and, hence, the harder it will be for the in-kind creation-redemption mechanisms to operate smoothly. Choppiness there can lead to larger premiums and/or discounts when we compare share prices to net asset value, and increase the chances of significant year-end tax distributions. Then, too, there's habit. For better or worse, the investment community has become accustomed to tying the hands of ETF portfolio managers and however much this grew from choice rather than necessity, old habits are hard to break.
Hence the arrival of active ETFs has, from a commercial standpoint, been underwhelming. Another factor may have been the fact that the first active ETF filing was made by Bear Sterns shortly before its demise. Not surprisingly, nobody in the investment community was in the mood for that!
The ultimate challenge, though, for active ETFs is the fact that there's a far easier, and thus far hugely successful, way to bring active investing strategies to the realm of ETFs, specifically, the passive-aggressive approach: "my index is better than your index."
As far back as thee early 2000s, ETF investing was not nearly as passive as many believe.
Back then, the SPDR S&P 500 ETF (SPY) was the big gorilla, the one everybody knew of and talked about. It was assumed that if you invested in SPY, you were taking a passive approach, that you were going to resist the temptation to try to beat the market.
Not so fast!
ETF investors were not limited to SPY. They could just have easily has chosen the NASDQ 100 ETF (QQQQ). In calendar 2001, SPY lost 12 percent while QQQQ lost 27 percent. So an investor who chose SPY could have taken credit for having achieved a return that, while negative, was still 15 percentage points better than what would have been achieved through selection of a different, well-known, well-traded, ETF based on a then-admired index. Hence the choice to track the S&P 500 wasn't really passive at all. In this context, we see it as a successful active decision.
Another well-known choice back then was the iShares Russell 2000 ETF (IWM). In calendar 2001, it actually gained 1.8 percent. In this context, the investor who chose SPY doesn't look so good. It is no longer acceptable to simply shrug one's shoulders in response to the SPY's 12 percent drop and simply cite a passive decision to track the market. Such an investor could just have easily have chosen to track the Russell 2000, which beat the S&P 500 by nearly 14 percentage points. Here, too, the choice to track the S&P 500 cannot be seen as passive, but must instead be viewed as an unsuccessful active decision.
Theorists might point to the larger, more liquid and better known stocks that make up the S&P 500 and try to argue that it is the default benchmark. Whatever the merits of such a view, try explaining that to a money manager coping with an angry client who's cousin had an adviser that put him in IWM.
And even when we consider theory, note that the S&P 500 does not represent the world as a whole. It doesn't even represent the U.S. equity market. Instead, it's a choice to track a sector-balanced large-cap strategy within the U.S. market. The NASDQ 100 has a generally large tech-oriented flavor while the Russell 2000 represents a smaller-cap sector-balanced approach.
So an investor who chooses to track the S&P 500 is not being passive at all. Instead, he/she is making an active choice to go large-cap core, and like active investors everywhere, can be held accountable for the success or failure of such a choice.
Imagine how much more active a decision to track the S&P 500 becomes when we consider additional alternatives from Dow Jones, FTSE, MSCI, Russell, Wilshire, and also the broad product line from S&P's own indexation business. The active nature of the choice continue to grow as we consider different regions, and different asset classes.
It's all well and good for the media to focus, as a matter of custom and convenience, on just a few indexes (mainly the Dow Jones Industrials, the S&P 500 and the NASDAQ 100). After all, it would be hopelessly chaotic if we all looked at everything all the time. But when it comes to investing real money, pointing to the S&P 500 and saying that's "it" doesn't work, especially if there are many alternative indexes that could, if tracked, put more money in your pocket.
So if we can't rest easy following the S&P 500, how can we benchmark our efforts? In fact, benchmarking is an incredibly complex topic that generates reams for published research and huge product lines (well into the thousands) for the major index providers and smaller research shops as well. The weight of this massive debate will have to be carried by the academicians, as well as by the researchers and sales people who work for the index providers. For us at Portfolio123, we can stick with the benchmarks we have now (including the S&P 500) so long as we understand that these are choices we make for our own convenience. But when we start putting real money on these indexes (via ETF investing), all bets are off and the S&P 500 (more specifically, the ETFs that track the S&P 500) has to compete just like all the others to make it into our screens and rise high in our sorts.
Bottom line: Forget about passive investing. It doesn't exist. It never really existed. Don't look for it in the ETF world. And most important, don't pay attention to the disturbingly high number of commentators out there who complain of ETFs having strayed from their so-called passive roots.
A simple passive-aggressive strategy
Here's a good way to introduce yourself to the dynamic of ETF screening. Start by creating a passive-aggressive universe consisting on the kinds of ETFs most likely being referred to by advocates of passivity.
You can set it up as a custom universe:
Alternatively, you could leave the universe setting at the default (All ETFs), and articulate the following screening rules:
Whichever way you define the universe, add a simple volume filter such as AvgVol(20)>=5000. Then establish a higher-is-better quick rank based on sma(5)-sma(20) (5-day simple moving average minus 20-day average).
Start by backtesting the top 10 ETSs over the past five years using four-week holding periods and zero slippage. You'll notice that the passive-aggressive portfolio outperformed the S&P 500 benchmark through 3/3/09.
Now for the hard part. Set slippage to 0.25%. This causes the portfolio to fall a bit behind the S&P 500. This will be a significant challenge in ETF screening; achieving enough positive relative performance to overcome reasonable slippage assumptions. As you fine-tune a strategy, here are some things to keep in mind:
- The more aggressively you screen for volume, the more you can reduce your slippage assumption.
- Reduce the number of ETFs in your portfolio. Remember, these are all funds containing many stocks. You don't need 25 ETFs. Three to five will often suffice, and in some cases, even one will do.
- Look for opportunities to stretch you holding periods. Given the emphasis on technical and statistical rules in the ETF screener, it's tempting to rebalance daily or weekly. Consider resisting such a temptation. Because these are funds, rather than individual corporations, the price and volume trends may have different flavors. After all, the simple moving average or MACD for an ETF is the aggregate of the simple moving averages or MACDs of many different securities, not all of which move in the same direction at the same time. Don't be surprised if you find that even technical factors need more time to assert themselves. You may find that longer rebalancing intervals, say four weeks, outperform shorter ones, even before counting slippage.
In this case, I was able to generate some improvement, most noticeable before the laste-2008 collapse but sill evident after that, even if just modestly, by restricting the portfolio to just three ETFs and rebalancing every three months.
For the record, as of 3/3/08, the top three ETFs were:
PowerShares FTSE NASDAQ Small Cap (PQSC)
First Trust NASDAQ-100 Equal Weighted ETF (QQEW)
Claymore/Raymond James SB-1 Equity Fund (RYJ)
This is a particularly interesting example of passive-aggressive. PQSC and QQEW eschew the S&P 500's large-cap bias by going small. PQSC expressly seeks small-cap stocks. QQEW uses standard NASDQ 100 stocks, but its use of equal weighting dampens the impact of the largest names. RYJ, meanwhile, is definitely an eyebrow raiser. Its index consists of stocks assigned Strong Buy ratings by the Raymond James & Co. analysts. I can't really assign RYJ to the Quant Model method since it does not seem that the analysts use any such approach. Essentially, by using RYJ in lieu of SPY, we opt for an equally-weighted portfolio (modified based on volume-related rules) of stocks chosen by Raymond James in lieu of a market-cap weighted portfolio of stocks chosen by S&P's index advisory committee.
Still, RYJ is clearly an oddball ETF. Perhaps you don't like the comparison between its selection approach and that of S&P. One could argue that RYJ is almost like an active ETF.
Considering the creativity of ETF sponsors nowadays (especially an outfit like Claymore), you can expect to encounter oddballs often. So when you screen for ETFs, you should be much more aggressive about using the Ticker function, an old standby that many in Portfolio123 use rarely, if at all. I add the following rule to my screen: Ticker("RYJ")=0. The backtest result was marginally better this time around (meaning the Raymond James analysts are not, at least so far, doing a great job competing with the S&P selection committee). And now, in addition to PQSC and QQEW, we have First Trust DB Strategic Value Index Fund (FDV).
Despite knocking out RYJ, there may still be reason to quarrel with the final list. Two out of the three ETFs are small-cap in nature. Is that overkill? Might it become more so if at other times, the screen produces three ETFs that pursue the same strategy. There is something to be said for diversifying against execution risk (e.g., one sponsor may have a better small-cap value approach than another), but perhaps the benefits of trying to pick among them may not be worthwhile. It may be preferable to use our screen to choose, say, between small-cap value, mid-cap growth, mid caps in general, and so forth.
So I refined my universe even further to limit consideration to only one ETF from each possible size-style configuration. I include ETFs that track major indexes like the S&P 500 as well. I do this by setting the quick rank to AvgVol(20) (higher is better) and downloading a spreadsheet. Then, I eyeball the list choosing the highest ranking (in terms of volume) ETF from each possible strategy. I create a custom list from the 14 tickers I wind up with and re-run the screen using the InList("PassAggrETFs") rule in lieu of the volume and RYJ-exclusion rules. The backtest result is marginally lower than before, but still in the same ballpark. And that was with 0.25% slippage. Considering I'm now looking only at the most widely traded ETFs, I could probably reduce slippage.
Here's my new list (after I re-set quick rank to the sma criteria):
PowerShares QQQ Trust (QQQQ)
iShares Russell Midcap Value (IWS)
iShares Russell Midcap Growth (IWP)
If I wanted my passive-aggressive strategy to produce just one ETF (an approach that also backtests reasonably well), it would be QQQQ as of this writing.
Anyway, this is a sample of passive-aggressive ETF investing. The kinds of ETFs in this universe are quite tame, much more traditional in nature, compared to much of what we'll be seeing later on. But even here, we were able to get a little bit of positive performance relative to the S&P 500 even with little more than a rank criterion that was, frankly, off the cuff.
The latter point is especially noteworthy. Notice how little attention I gave to the basics of screening and ranking. Most of my effort was directed toward universe creation and refinement, and backtest parameters. I would expect the typical Portfolio123 user to be more attentive to screening rules and the quick rank than I have been here. But relative to what you may be accustomed to with stocks, I do believe that ETF universe-list refinement will play a much larger role in your overall efforts. So I strongly recommend taking some time, in the early going, to really get comfortable with universe creation (via the interface and/or the Groupings functions) as well as working with rules using Ticker and InList.
Turning up the heat
Once we cease to see passivity as the Holy Grail of ETF investing, we are ready to look at the full ETF landscape wherein the threshold of aggressiveness has increased.
In the next blog, we'll examine PowerShares and some similar families and how they create ETF portfolios that are conceptually in line with the kinds of stock portfolios created right here by Portfolio123 users. After that, we'll look at fundamentally-weighted indexes and ETFs that have generated lots of press but also, many questions when it comes to performance. Then, we'll move to the new big thing: ProShares, Rydex and Direxion; ETF families that use leverage and/or short ETFs to blaze new trails when it comes to strategic aggressiveness.