By Janet Flanders Johnston, portfolio manager at TrimTabs Asset Management.
Meet the next generation of ETFs: Smart Alpha
The next generation of innovative equity ETFs may combine quantitative analysis with disciplined active management. Both purely active and purely passive products have negative attributes. By combining the best of both approaches, we believe a more efficient ETF that consistently generates alpha with the same amount of market risk can be created.
“Smart Beta” is a type of ETF that uses alternative index construction rules instead of the typical cap weighted strategy. While flows in the ETF industry have clearly favoured passive “smart beta” products in recent years, these ETFs are simply factor ETFs. However, factors are volatile. If a factor is out of favor, these ETFs will underperform major market indices. For example, academic studies undisputedly confirm that the value factor outperforms over the long term. In reality, value ETFs have significantly underperformed major market indices since December 2016 during one of the strongest bull markets in history. To be used effectively, it is the investor who needs to be “smart” – not the ETF.
When a market impacting event occurs, such as the bursting of the volatility index bubble, or periods of high macro stress like the financial crisis, volatility spikes and correlations rise between sectors and stocks. Investors ignore individual characteristics of companies and focus on market risk and beta. Everything moves in the same direction. Alphas are trampled, along with average stock pickers. In search of outperformance, active managers who fail to have a disciplined process may expose investors to style drift, concentrated positions, leverage, or closet indexing.
Today, volatility remains historically low, along with correlations between sectors and stocks. In this environment, individual characteristics of each company become more important than any macro, or event risk. Stock alphas come out to play, and there is an opportunity for active managers to outperform passive managers.
At TrimTabs Asset Management, our process of seasoned, disciplined active management combined with our multi-factor quant models focused on free-cash-flow, or operating cash flow minus capital expenditures, creates more robust “all weather” core equity ETFs. The models do the heavy lifting by ranking all the stocks in a universe. Focusing on free cash flow growth allows us to skirt the financial shenanigans that are discretionary, as well as other non-cash factors. We can get a true picture of the organic growth of a company.
Free cash flow combined with strong balance sheets creates a list of high quality names. We then incorporate our third factor – share count reduction. By pairing this factor with strong balance sheets, we try to find companies that are not leveraging up their balance sheet to financially engineer earnings.
As active managers, we manage sector and country exposure, along with tax considerations. We also factor in the impact of variables that would not show up in a quantitative model. This includes factors such as political, legislative, and regulatory risk, as well as the impact of tax reform and disruptive technologies. Lastly, we can factor a company’s positioning within an industry, and other fundamentals.
Alpha, or excess risk-adjusted returns over a major market index, can only be generated with active management. With increased investor interest, ETF providers are ramping up their launches of active ETFs. However, one major ETF provider appears to be merely adding more rules. For example, one issuer claims to only be active, albeit only to insure the stocks are tracking their factor. Is this really active management with true discretion, or just another version of factor investing?
TrimTabs’ goal is to deliver “Smart Alpha” by combining active management with our multi-factor models based on free cash flow in a modern and efficient manner to create “all weather” portfolios. These quality companies are sitting on cushions of cash that tend to outperform in both up and down markets. Last June, TrimTabs Asset Management expanded to a family of funds by launching TrimTabs All Cap International Free Cash Flow ETF (TTAI US) to complement our flagship fund, TrimTabs All Cap US Free-Cash-Flow ETF (TTAC US).
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)