Wall street sign in New York with American flags and New York Stock Exchange background.
kasto/123RF

Actively managed U.S. equity ETFs have a tough time matching, let alone surpassing, their passive rivals. But will adverse market conditions give active managers a better chance to shine in 2019?

Looking back over the mostly bullish times of the past 10 years, passive funds that track market-cap-based indexes have had star-studded risk-adjusted returns. A traditional index ETF, such as one  tied to the benchmark S&P 500, is always fully invested and broadly diversified. Such products charge the lowest fees, giving them a consistently lower performance hurdle to clear. And they’re always well positioned to capture momentum-driven trends such as booming technology stocks.

Introducing RBC iShares

All things ETFs, now in one place. Brought to you by RBC Global Asset Management and BlackRock Canada.

See it to believe it.
RBC ishares

Conventional index ETFs even win praise — to a point — from some of their most vigorous competitors. Among them is Som Seif, president, CEO and founder of Toronto-based Purpose Investments Inc. When the U.S. market was going strong, says Seif, managers who took a more prudent approach to managing risk, charged higher fees and were not fully invested “would have had an extremely hard time to keep up with the market-cap indexes.”

However, Seif expects 2019 to be less favourable for passive investing. The U.S. market’s poor 2018 performance, he says, is a sign that the bull market that began in 2009 won’t last much longer. Put simply, investors face two main risks, he says. One is the risk of losing money. The other is the risk of missing opportunities.

To address these risks, Purpose offers three U.S. equity strategies, with management fees that range between 55 and 65 basis points. Of the three, Purpose US Dividend Fund is the sole long-only offering. This rules-based strategy invests in an equally weighted portfolio of 60 dividend-paying companies, with a 20% sector cap.

Dividend-themed strategies, considered to be a more conservative approach than investing in the entire market, are well represented in the U.S. equity category. They include ETFs sponsored by BlackRock Asset Management Canada Ltd., BMO Asset Management Inc., Fidelity Investments Canada ULC, Invesco Canada Ltd., RBC Global Asset Management Inc., Vanguard Investments Canada Inc. and WisdomTree Asset Management Inc., all based in Toronto.

As for the Purpose lineup, its two other U.S.-focused ETFs each employ alternative strategies. Purpose Enhanced US Equity Fund invests up to 130% of its net asset value in value-style equities, while maintaining net market risk of 100% through shorting the S&P 500 Index by up to 30%. Purpose Premium Yield Fund holds selected U.S. stocks while writing deep out-of-the-money put options to generate premium income while cushioning the impact of falling stock prices. “In the late stages of a bull market, you want to have risk management,” Seif says.

The debate over whether active is better than passive should really be about high cost versus low cost, contends Todd Schlanger, senior investment strategist with Vanguard Canada and a member of the U.S.-based Vanguard organization’s global investment strategy group. “The reason indexing does on average better than, let’s say, 70 or 80% of actively managed funds is because the costs are lower,” he says.

In the U.S. equity category, six of the 11 ETF listings that receive Morningstar Canada’s top five-star rating for risk adjusted returns are market-cap-based index funds. Among them are the $4.8-billion BMO S&P 500 Index ETF, the $1.9-billion Vanguard S&P 500 Index ETF and the $1.3-billion iShares Core S&P 500 Index ETF.

All three have management fees of 10 basis points or less. That’s much cheaper than those of factor-based or fully actively managed ETFs, most of which are priced anywhere from 20 to 60 basis points higher. “If you make the cost of active more competitive to indexing, then it can start to play a more viable role in a portfolio,” says Schlanger. Vanguard Canada’s U.S. equity offerings include the factor-based Vanguard U.S. Dividend Appreciation Index ETF, whose management fee is 0.28%.

“A market-cap-weighted index is low cost, broadly diversified and reflective of the overall market performance,” says the Vanguard strategist. “So we think that is a great starting place for investors when they think about asset allocation.”

Schlanger casts doubt on the ability of active managers to position themselves ahead of bull and bear markets, arguing that most major changes in market direction are unanticipated. But investors can be successful with active management, he says, “if you can identify talent for outperformance and you can keep the relative cost of that strategy competitive to what you could achieve with indexing, and you’re willing to be patient with that strategy or that manager through periods of underperformance.”

Most fully active or factor-based strategies rely on combinations of value and growth criteria such as price-earnings ratios and earnings growth rates. But the search for alpha has led to the development of other innovative strategies such as that of First Asset U.S. Buyback Index ETF (CAD Hedged).

Designed to replicate the performance of the CIBC U.S. Buyback Index net of expenses, the two-year-old ETF holds an equally weighted portfolio, rebalanced quarterly, of about 40 large-cap companies that have significantly and consistently reduced the number of their issued and outstanding shares. The quantitative stock-selection process factors in the amounts and frequency of buybacks, with other criteria designed to reduce frictional trading costs by restricting portfolio turnover.

“These companies that buy back shares, and buy back shares consistently, generally are highly profitable companies that generate excess capital,” says Ian de Verteuil, managing director and head of portfolio strategy, quantitative and technical research, with Toronto-based CIBC World Markets Inc.

For investors in non-registered accounts, a buyback strategy has the added attraction of tax efficiency, de Verteuil says. That’s because buybacks tend to boost stock prices, increasing the potential for realizing tax-advantaged capital gains when the shares are sold.

As would be expected for strategies that attempt to beat the market, the First Asset ETF’s management fee of 60 basis points is more expensive than that of a passive ETF. On the plus side, as of Nov. 30 the ETF’s average annual return of 15.67% since its September 2016 inception is nearly two full percentage points higher than the S&P 500 Total Return Index. “Obviously there is a hurdle to overcome,” says David Barber, vice-president, national accounts, with Toronto-based First Asset Investment Management Inc. “But so far we’re overcoming the hurdle.”