Combine Active, Passive ETFs to Make a Stronger Portfolio

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Before filling out an investment portfolio, ETF investors should consider the best practices in portfolio construction and potentially look to actively managed strategies to enhance a portfolio consisting of cheap, passive index funds.

On the recent webcast (available on demand for CE Credit), Active or Passive? Why You Should Use Both!, Matthew Bartolini, Head of SPDR Americas Research for State Street Global Advisors, painted a picture with a changing landscape as index-based funds garner a greater market share at the expense of actively managed funds. Active funds took up 87.5% of the overall investment market share back in 2001, but as of 2017, active funds made up a smaller 63.2% slice of the market.

ETFs have been a huge contributing factor to this shift toward passive index-based fund investments. For instance, in 2017, U.S.-listed equity ETFs attracted $334.6 billion in net inflows and fixed income-related ETFs brought in $127.4 billion in inflows.

Low-cost, passive index-based ETFs have been gaining momentum at the expense of active funds. However, it is also surprising that active funds continued to see assets shrink, especially as 48% of large-cap active managers outperformed in 2017, the highest percentage in eight years.

"The active environment has improved in 2017 as stock correlations collapsed to 15-year lows and dispersions started widening again," Bartolini said.

"Decoupling sector correlations and above average dispersions point to a constructive environment for sector rotation strategies," he added.

Bartolini also pointed out that active managers have performed better in certain asset categories. For instance, a lower percentage of active managers underperformed benchmarks in emerging market equities and foreign large blends.

Looking at fixed-income categories, a lower percentage of active managers underperformed in global fixed-income and investment-grade intermediate funds. Bartolini argued that it is better to "select active managers with expertise in less efficient sectors to add additional diversification."

On the other hand, when scrutinizing areas where active managers have been less capable of outperforming benchmarks, investors may consider passive strategies that cover areas like U.S. large-cap blend, U.S. mid-cap blend, U.S. small-cap blend and high-yield funds.

"Use an index-based investment as the core of the allocation and pursue alpha through active sector or industry rotation," Bartolini said.

For example, Rusty Vanneman, Chief Investment Officer at CLS Investments, revealed that at CLS Investments, core portfolio positions may follow allocations along the lines of 18% active funds, 41% market-cap weighted funds and 42% smart beta funds. These smart beta strategies may also be a good middle ground between active and passive as the indexing methodologies follow traditional actively managed styles but the funds come with the lower cost associated with passive index funds.

Furthermore, Vanneman broke down the equity and fixed-income allocations. CLS Investments focus more on alternative index-based strategies in its equity portfolio, with a 40% tilt toward market cap-weighted funds, 58% smart beta and a smaller 2% active. On the other hand, CLS Investments saw more opportunity for alpha generation through active strategies in its fixed-income portfolio with 45% active funds and 52% market-cap weighted funds.

No matter how investors and advisors choose to break down their portfolio allocation methodology, Larry Whistler, President and Chief Investment Officer at Nottingham Advisors, argued that "all investing involves 'active' decision making."

Whistler also singled out the actively managed SPDR Blackstone/GSO Senior Loan ETF (NYSEArca: SRLN) to help investors with better exposure since a manager is more freely able to weave in and out of the fixed-income market. Blackstone/GSO, which subadvises SRLN, is backed by one of the largest senior loan asset managers in the world. The subadvisor is able to "access new issues, exploit market inefficiencies, avoid cap-weighted concentrations and embrace undervalued sectors," according to Whistler.

Financial advisors who are interested in learning more about portfolio construction can register for the Thursday, February 15 webcast here.

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