My colleague, Joe Smith, CFA, wrote about CLS’s strategy to beat broad market averages through the use of ETFs in his December 13 Weekly Market Review. In this week’s review, I’m expanding on the different ways active managers can use ETFs to outperform benchmarks.
Traditionally, there are two well-known ways to be an active manager and seek to outperform a selected benchmark: asset allocation and security selection. CLS, as an expert ETF strategist since the early 2000s, has focused more on asset allocation for our clients. Through Risk Budgeting, we use asset allocation to find the optimal mix of many different asset classes to create a holistic portfolio for the client’s risk tolerance or Risk Budget. By utilizing broad asset allocation and global diversification, we admit some level of uncertainty about the future price movement around the globe and, therefore, diversify to several different areas of the market. Active asset allocation (or risk allocation as we like to think of it) can outperform the market by tilting towards asset classes that may have higher returns and avoiding those with lower returns. Think about tilting towards value stocks in 2016 and underweighting growth stocks as an example.
Asset allocation is a top-down approach. Security selection, on the other hand, seeks to outperform the market by completing bottom-up research and finding individual stocks, bonds, or alternatives in each asset class that will outperform the market. Individual stock pickers use this approach; they look for individual companies in the basket of value stocks to invest in and to avoid.
The first ETFs launched were great building blocks for asset allocation as they provided inexpensive ways to access market-cap-weighted asset classes from around the globe, while remaining very liquid and efficient. As the ETF industry continues to evolve, so will our management of these versatile vehicles.
Through smart beta ETFs (which are included in the 2016 and 2017 CLS Investment Themes), we can not only fulfill our promise of diversified asset allocation, but also improve upon our security selection. How? Smart beta ETFs, by definition, are index funds that weight their holdings (stocks) by alternative methods other than pure market-cap. For example, a broad U.S. large-cap ETF, such as the iShares S&P 500 ETF, will give investors relatively inexpensive market-cap exposure to the largest U.S. companies. But, it’s possible to improve on returns and risk management by using a smart beta ETF instead.
The Guggenheim S&P 500 Pure Value ETF will alternatively weigh its holdings based on the highest value fundamentals, such as price-to-book ratios. The resulting portfolio looks a lot different from the S&P 500 Index and will perform differently too.
The end result can help better manage risk and outperform an index. After all, in order to outperform the market or index, investors must be willing to differ from it.