Some might consider the notion of adding Alpha (performance relative to an index) in ETF portfolios an oxymoron along the lines of “jumbo shrimp” or “healthy tan”, writes Herb Morgan, President and Chief Investment Officer of Efficient Market Advisors, LLC. After all, ETFs are constructed to mirror indexes, and indexes are the vehicle of choice for academic purists and penny pinching cheapskates. (I believe I fall into both categories.) Yet today there is no shortage of money managers trying to use index products for the generation of Alpha.
Alpha is of course a relevant concept which is usually used when comparing performance to an index. I think a better use of Alpha would be to compare performance to other managers with similar risk characteristics. In either regard, ETFs are a solid choice for managers that are “Seeking Alpha”.
That is not to say as many do that one can add value through Tactical Asset Allocation. Even the folks at Russell admitted the TAA deficiency when Russell director Stephen Roberts said a 2002 Towers Perrin study showed pooled funds which utilize TAA subtracted value in 24 out of 34 funds surveyed. Of the ten funds that added value, five added less than thirty basis points of return per year.
Strategic Asset Allocation is limited by lack of adequate data from which to optimize weightings in selected asset classes. Just try optimizing a portfolio of eight core asset classes for a ten year holding period! There just aren’t enough ten year holding periods of data available to make any definitive proclamations on the best allocation for a given level of risk.
When creating an efficient or optimal portfolio where one is limited by the constraints of data quantity, a little dose of common sense can aide in the quest for Alpha. Here are my guidelines:
- Bonds: One should recognize that interest rates have declined for roughly 24 years and a large component of the historical returns in fixed income are derived from that trend. For this reason, I chose to override the system by limiting my maximum exposure to the intermediate and longer end of the yield curve.
- Real Estate: It’s important to recognize the unique characteristics and correlation benefits of REITS but these too need to be constrained when running an optimization program.
- Cash: Most optimization programs use historical money market data or the like for estimating the return on cash. I think this is probably a mistake so I override the historical return with an expected return of about 3%.
- International: International equities have increased their correlation with US equities marginalizing the expected gains to a portfolio. Other managers are increasingly using Emerging Markets here but I remain not yet convinced. I still have dreams of Peso devaluations and the Asian currency crisis.
Managers can add Alpha by utilizing ETFs. When compared to an open end active or index funds, ETFs are less expensive. ETFs do not have a cash drag, and are likely not to make capital gains distributions.
A manager can add Alpha through execution of buy and sell orders rather than using traditional end of day pricing provided by open end index funds. Year end tax swap strategies between similarly styled ETFs are another way a manager can use the tax code to add Alpha to a portfolio.
A large number of academic works suggest that stock picking does not add value over an index. Being an Efficient Markets believer I readily subscribe to this theory. However, to be intellectually honest one needs to recognize that the studies were all done on diversified portfolios. That is to say no manager of a portfolio of 100 stocks can consistently or predictably beat the market. My experience is that any one manager is only capable of truly knowing a very limited number of companies. Of course publicly available funds and managed account are diversified. For this reason the performance of a primarily ETF portfolio could be enhanced with the inclusion of a small number of individual stocks that are well known to the manager.
Intermediaries have been slow to embrace ETF money managers. Combing the approved managers list at the wire-house firms proves this point. Even direct to consumer managed money platforms are void of ETF managers. I suspect that will change over the next few years as investors continue to embrace the ETF concept.
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