Analysis of Alpha Architect ETPs
analysis, exchange-traded product, factor investing

A recent article in The Wall Street Journal profiles the CEO of Alpha Architect LLC, an upstart active investment manager. The firm currently advises five exchange-traded products (ETPs). Four of these ETPs have a sufficiently long history to be analyzed using Alpholio™’s patented methodology.

All of the following analyses employ the simplest variant of the methodology. For each analyzed ETP, the variant constructs a reference portfolio of up to six ETFs that most closely tracks periodic returns of the ETP. Both the membership and weights of ETFs in the reference portfolio are fixed over the entire analysis period.

Let’s start with the ValueShares U.S. Quantitative Value ETF (QVAL). Here is a chart of the cumulative RealAlpha™ for this ETP (to learn more about this and other performance measures, please visit our FAQ):

Cumulative RealAlpha™ for ValueShares U.S. Quantitative Value ETF (QVAL)

The ETP produced a significantly lower cumulative return than that of its reference ETF portfolio. It also had a higher volatility due to a relatively small number of deep-value holdings. This was also reflected in a considerably elevated RealBeta™, assessed against a broad-based domestic equity ETF.

The following chart with statistics shows the fixed composition of the reference ETF portfolio for QVAL:

Reference Weights for ValueShares U.S. Quantitative Value ETF (QVAL)

The ETP had equivalent positions in the First Trust Large Cap Value AlphaDEX® Fund (FTA), SPDR® S&P® Retail ETF (XRT), PowerShares S&P SmallCap Information Technology Portfolio (PSCT), iShares North American Tech-Multimedia Networking ETF (IGN), First Trust Industrials/Producer Durables AlphaDEX® Fund (FXR), and iShares U.S. Oil Equipment & Services ETF (IEZ). These ETFs correspond to average exposures QVAL generated over the evaluation period.

Let’s move on to the ValueShares International Quantitative Value ETF (IVAL). Here is a chart of cumulative RealAlpha™ with statistics for this ETP:

Cumulative RealAlpha™ for ValueShares International Quantitative Value ETF (IVAL)

The ETP added significantly more value than its reference ETF portfolio, but only beginning in the second half of last year. This is why the article singles out a recent outperformance of just this product:

…value-focused fund of overseas stocks is beating all its rivals over the past year.

The ETP produced this excess return at the expense of a substantially higher volatility than that of its reference ETF portfolio.

The following chart with associated statistics illustrates the static composition of the reference ETF portfolio for IVAL:

Reference Weights for ValueShares International Quantitative Value ETF (IVAL)

The ETP had equivalent positions in the WisdomTree Japan Hedged Equity Fund (DXJ), Guggenheim CurrencyShares® Australian Dollar Trust (FXA), iShares MSCI South Korea Capped ETF (EWY), iShares MSCI Spain Capped ETF (EWP), WisdomTree Japan SmallCap Dividend Fund (DFJ), and iShares MSCI Germany ETF (EWG).

Next, let’s take a look at the MomentumShares U.S. Quantitative Momentum ETF (QMOM). Here is a chart of the cumulative RealAlpha™ with statistics for this ETP:

Cumulative RealAlpha™ for MomentumShares U.S. Quantitative Momentum ETF (QMOM)

The ETP failed to outperform its reference ETF portfolio of somewhat lower volatility.

The following chart with related statistics depicts the constant composition of the reference ETF portfolio for QMOM:

Reference Weights for MomentumShares U.S. Quantitative Momentum ETF (QMOM)

The ETP had equivalent positions in the PowerShares DWA Industrials Momentum Portfolio (PRN), Global X Social Media ETF (SOCL), aforementioned DFJ, PowerShares NASDAQ Internet Portfolio (PNQI), PowerShares Dynamic Leisure and Entertainment Portfolio (PEJ), and PowerShares DWA SmallCap Momentum Portfolio (DWAS).

Finally, let’s evaluate the MomentumShares International Quantitative Momentum ETF (IMOM). Here is the cumulative RealAlpha™ chart with statistics for this ETP:

Cumulative RealAlpha™ for MomentumShares International Quantitative Momentum ETF (IMOM)

The ETP significantly underperformed its reference ETF portfolio in terms of both the cumulative return and volatility. However, its RealBeta™ was well below that of the market.

The following chart with accompanying statistics shows the invariant composition of the reference ETF portfolio for IMOM:

Reference Weights for MomentumShares International Quantitative Momentum ETF (IMOM)

The ETP had equivalent positions in the iShares Mortgage Real Estate Capped ETF (REM), VanEck Vectors Vietnam ETF (VNM), iShares U.S. Medical Devices ETF (IHI), aforementioned FXA, Guggenheim CurrencyShares® Japanese Yen Trust (FXY), and aforementioned SOCL.

It should be noted that all of the above ETPs except for QVAL have traded at a considerable premium to their net asset value (NAV). For example, as of this writing, IMOM’s one-year price return was 8.50% compared to a 3.10% NAV return. Such pricing discrepancies could partially explain the presence of REM (a domestic real-estate fund) and IHI (a domestic medical device fund), in the reference ETF portfolio for IMOM.

In sum, the majority of Alpha Architect ETPs have so far delivered unimpressive results after a comprehensive adjustment for volatility and exposures. Since the oldest product has less than three years of history, only time will tell whether the performance of these ETPs vs. their reference ETF portfolios will eventually improve. The challenge of any factor investing, including value and momentum, is not only the cyclical variation of performance but also the selection of individual securities to implement the factor.

To learn more about the Alpha Architect and other ETPs, please register on our website.


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Introducing ETP Analysis Service
active management, analysis, exchange-traded fund, exchange-traded product, portfolio

Alpholio™ has recently added the ETP Analysis Service to its platform. The exchange-traded product (ETP) is an exchange-traded fund (ETF), exchange-traded note (ETN), NextShares ETMF®, or other exchange-traded financial instrument.

The main motivation behind the new service is the availability of ETPs that do not track market-cap weighted indices. In particular, this includes “smart beta” (a.k.a. “strategic beta“) strategies that blend active and passive management. Due to the former aspect, smart-beta ETPs resemble traditional actively-managed mutual funds. Consequently, they can be analyzed with Alpholio™’s patented methodology, which constructs a custom reference portfolio of ETFs for each analyzed fund.

This leads to an apparent paradox: an analyzed ETP (which may be an ETF) is to be replicated by a portfolio of ETFs. Why do this at all? Just as with a traditional mutual fund, for several main reasons:

  • To determine whether active management aspect of the ETP adds value on a truly risk-adjusted basis
  • To understand the exposure of the analyzed ETP to various factors. This helps eliminate excessive exposures in the overall investment portfolio.
  • To replicate the ETP’s performance with other ETFs that may have preferable characteristics, such as lower fees, smaller trading premia or spreads, accessibility, etc. Conversely, to simplify a portfolio by substituting multiple ETFs with a single ETP.
  • To discern periods of underperformance and outperformance of the ETP after adjustment for its exposures.

Let’s demonstrate the new ETP Analysis Service in action. First, we will analyze the PowerShares FTSE RAFI US 1000 Portfolio (PRF). This ETP tracks the FTSE RAFI US 1000 Index, which

…is designed to track the performance of the largest US equities, selected based on the following four fundamental measures of firm size: book value, cash flow, sales and dividends. The 1,000 equities with the highest fundamental strength are weighted by their fundamental scores.

To conduct the analysis, we will use the simplest variant of Alpholio™’s methodology, which builds a reference ETF portfolio with both fixed membership and weights. The following chart and related statistics show the cumulative RealAlpha™ for the ETP (to learn more about this and other performance measures, please visit our FAQ):

Cumulative RealAlpha™ for PowerShares FTSE RAFI US 1000 Portfolio (PRF)

Over the five years through July 2016, the ETP added a small amount of value vs. its reference ETF portfolio of comparable volatility. The RealBeta™ of the ETF was the same as that of a broad-based equity market ETF.

The following chart with accompanying statistics presents the fixed composition of the reference ETF portfolio for the analyzed ETP:

Reference Weights for PowerShares FTSE RAFI US 1000 Portfolio (PRF)

The ETP had major equivalent positions in the iShares Russell 1000 Value ETF (IWD), Vanguard Value ETF (VTV), iShares Core S&P Total U.S. Stock Market ETF (ITOT), SPDR® S&P® 500 Value ETF (SPYV), PowerShares BuyBack Achievers Portfolio (PKW), and Guggenheim S&P 500® Pure Value ETF (RPV). Clearly, this ETP had a very strong exposure to the large-cap value factors represented by reference ETFs. (The Other component in the chart collectively depicts additional six ETFs with smaller weights, some of which were effectively zero.)

In the second example, let’s analyze the Guggenheim S&P 500® Equal Weight ETF (RSP). This ETP

Seeks to replicate as closely as possible the performance of the S&P 500 Equal Weight Index, before fees and expenses, on a daily basis.

Here is the chart with related statistics of the cumulative RealAlpha™ for this ETP:

Cumulative RealAlpha™ for Guggenheim S&P 500® Equal Weight ETF (RSP)

Over the five years through July 2016, this ETP also added little value vs. its reference ETF portfolio. Its RealBeta™ was above that of a broad-based stock market ETF.

The final chart and statistics show the static composition of the reference ETF portfolio for the ETP:

Reference Weights for Guggenheim S&P 500® Equal Weight ETF (RSP)

The ETP had major equivalent positions in the First Trust Large Cap Core AlphaDEX® Fund (FEX), iShares Russell Mid-Cap Value ETF (IWS), PowerShares S&P 500 Quality Portfolio (SPHQ), PowerShares S&P 500® High Beta Portfolio (SPHB), iShares Russell Mid-Cap Growth ETF (IWP), and Consumer Discretionary Select Sector SPDR® Fund (XLY). The Other component in the chart collectively represents additional six ETFs with smaller constant weights, one of which was effectively zero.

As could be expected, due to equal-weighting of its positions this large-cap ETP had a significant tilt toward mid-cap stocks, especially of value characteristics. In addition, the ETP had considerable exposure to economic sectors such as consumer discretionary, financials, technology, and industrials.

If you would like to take advantage of the new ETP Analysis Service, please register on our website.


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Exchange-Traded Product Statistics
exchange-traded fund, exchange-traded product

A paper from PwC provides interesting statistics on exchange-traded funds (ETFs) and products (ETPs). [Alpholio™ uses the latter term to encompass ETFs, exchange-traded notes (ETNs), and other similar investment vehicles.]

As of 3Q2013, about $2.2T was invested in almost 5,000 ETPs globally:

PwC Global ETF and ETP Totals

Thanks to a large single market, an average ETP had much more AUM in the US than elsewhere (however, this does not take into account the typical right skew of the AUM distribution, whereby a small number of funds hold the majority of assets):

PwC Global ETF and ETP per Region

Unlike elsewhere, in the US the majority of ETP AUM belong to retail investors:

PwC ETF Use by Region

The percentage of AUM in active ETFs, whose launch began only in 2008, is still small but growing:

PwC Assets in Active vs. Index ETFs

PwC Active ETF Launches

ETFs enable the shift from individual security selection to asset allocation, especially in liquid markets:

PwC ETFs Displacing Mutual Funds in US Equity Category

ETFs now cover a broad spectrum of asset classes:

PwC ETF Asset Class Coverage

All these findings strongly support the Alpholio™ thesis: the growing number, breadth and variety of ETPs enable more and more accurate assessment and substitution of actively-managed mutual funds and arbitrary investment portfolios for the benefit of investors.

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Is Index Investing Extinct?
active management, exchange-traded product

An article in Forbes laments a recent change of focus in ETF industry conferences from traditional “market-tracking” products to active investment strategies. By “market-tracking,” the author clearly means the classic market-cap weighted indexing that is prevalent in ETFs.

This brings up two questions. The first one: What really qualifies as active management? A one-time decision to invest in the entire stock market, such as through the Vanguard Total Stock Market ETF (VTI), is arguably an act of active management. So is a decision to split the investment portfolio between 60% VTI and 40% iShares Core Total U.S. Bond Market ETF (AGG). Likewise, a decision to adopt

“a fixed asset allocation to various asset classes based on an investor’s long-term needs.”

Periodic portfolio rebalancing to such a fixed allocation is also a form of active management, if not market timing, even if conducted on a fixed schedule. That is because one of its attributes is to “buy low, sell high,” i.e. lock in the gains in appreciated assets to cheaply purchase other assets in anticipation of a reversal to the mean.

Similarly, any modification of a “fixed” asset allocation in response to a change in the investor’s age or life circumstances also qualifies as active management.

Finally, it is worth noting that indices tracked by passive ETFs are also actively managed. Over time, the membership of securities in the index will change, and frequently so due to an arbitrary decision from a management committee rather than as a result of an explicit formula. A recent recomposition of the Dow Jones Industrial Average is one case in point. Another example is a recent switch of the Vanguard Emerging Markets ETF’s (VWO) underlying index from MSCI to FTSE, which caused all South Korean stocks to be removed from the fund.

Active management inevitably takes place at all stages of the investment process, even one based on passive instruments.

The second question that arises: Where is the ETF industry heading? The first wave of ETFs was about attaining economies of scale while implementing traditional market indices. It created a few dominant providers but resulted in a race to the bottom in management fees.

The second wave was about spreading horizontally to all niches of the market. Many of such exotic strategies failed to garner minimum assets of $50-100M that are typically required for an ETF to survive.

The third wave is about non-market-cap indexing, whether equal-weighted or fundamentally-weighted (“smart beta“). Such funds are a blasphemy to market-cap indexing purists who spend a lot of time poking holes in these strategies.

The next wave, pending regulatory approval of infrequent reporting of fund holdings, will be about active management. The ETF structure is attractive to actively-managed mutual fund vendors because it allows them to lower fees and survive the onslaught of cheap market-cap indexed ETFs.

All this makes traditional fee-based advisers nervous:

In the end, most advisers continue to do what’s in their clients’ best interest; they create a long-term asset allocation, buy low-cost index fund, and then stay the course!

The problem is that in many cases investors pay a recurring annual fee of anywhere from 0.2% to 1.5% of assets for a one-time setup of a portfolio pie-chart (frequently with small variations from the adviser’s “moderate” allocation template), followed by periodic rebalancing and reports. That enables a typical adviser to spend only about 11% of time on investment research, while devoting about 18% to client acquisition and prospecting, and 48% to client management.

In the end, the market will rightly decide what type of financial products survive and flourish. Marketing gimmicks aside, innovation in the ETF industry is a good thing because it gives investors more financial instruments to choose from at an ever-decreasing cost. Alpholio™ can use these new products to form reference ETF portfolios that better explain the performance of actively-managed mutual funds and arbitrary portfolios.

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Are ETF Fees Increasing?
exchange-traded product

An article in Forbes indicates that an average expense ratio (ER) of exchange-traded products (ETPs) increased from 0.61% to 0.62% over the 12 months to June 2013. The emphasis should be on average, as opposed to asset-weighted. That is because

Driving the fee increase is the cost of newly issued funds. Since 2010, the average net ER of a newly issued fund is 0.70%, according to Morningstar data.

Not surprisingly, as the ETP space becomes more crowded and basic indexing is increasingly well covered, more niche products with a small amount of assets under management (AUM) and, consequently, higher ERs are introduced. However, a straight ER average is less indicative of what a typical investor would pay compared to an asset-weighted average.

So, was there also an increase in asset-weighted fees? The 2012 and 2013 Lipper’s Quick Guides to OE [open-ended] Fund Expenses provide at least a partial answer. Here are the average asset-weighted fees for ETFs with “institutional” load types:

ETF Type 2011 ER 2012 ER % Change
All 0.330 0.306 -7.3
Diversified Equity 0.195 0.195 0.0
Sector Equity 0.417 0.397 -4.8
World Equity 0.451 0.424 -6.0
Other Equity 0.244 0.220 -9.8
Fixed Income 0.278 0.268 -3.6

For all ETF types, the ER decreased or stayed the same between 2011 and 2012, with an overall decline by about 7.3%. Therefore, on an asset-weighted basis, ETF fees exhibited an opposite trend to that on a straight average basis. That is great news for both ETF investors and Alpholio™, as the fund expense component of the (negative) excess return became smaller.

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Does”Going Active”Matter?
active management, exchange-traded product, mutual fund

A recent article in Barron’s contains an interview with industry experts about the pros and cons of a growing trend of actively-managed exchange-traded funds (ETFs). In that context, the discussion covered one of the most prominent mutual funds, The Fairholme Fund. One of the experts, Ben Johnson, global director of passive-funds research at Morningstar, stated that:

Q: Are there any strategies not suited for the ETF structure?

“Some of the most successful strategies on the equity side may never end up in this format. Look at Bruce Berkowitz, manager of the Fairholme fund (FAIRX). He is Morningstar’s equity manager of the decade. And yet he is pretty much running from something as liquid as a traditional mutual fund, to say nothing of ETFs.”

The counterpoint to that statement was posted by AdvisorShares:

“Lastly, the prominent mutual fund (Fairholme Fund) cited by Morningstar’s Ben Johnson is a poor example of the type of strategy that wouldn’t be a good fit for the liquidity of an ETF. In fact, the mentioned fund is the perfect example of the inefficiency of the mutual fund structure. In the Fairholme example, a lot of hot money comes in which is more wear and tear on the portfolio manager to put the cash to work. There is a cost to do that: spreads and settlement costs that impact both the new investors and your long-time shareholders. Then something happens: the fund falls out of favor, all the hot money is flying out, the PM is now selling what he can to meet redemption requests with those costs again impacting the departing shareholders, but also being born by the long-term shareholders. In reality, it is the long-term shareholders that will suffer the most by the tax inefficiency of the capital gain generating transactions.”

Luckily, from the Alpholio™’s perspective, it does not matter whether Fairholme is constructed as a mutual fund or an ETF. What really counts is how much value active management by Mr. Berkowitz adds or subtracts on a truly risk-adjusted basis (RealAlpha™). In the past eight years, the results have been mixed.

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ETP Tracking Errors on the Rise
exchange-traded product

A recent article from InvestmentNews indicates that the tracking errors of exchanged-traded products (ETPs) are on the rise. (Tracking error is a measure of how well an ETP matches its underlying index.) An Alpholio user might therefore be concerned with the effects of this trend on the results of our analyses of mutual funds and investment portfolios. There is actually no impact: In all its analyses, Alpholio always uses real (market) returns of both the analyzed and reference instruments instead of artificial (and hence practically unrealizable) indices. Therefore, in this context the tracking error is immaterial, as is the actual index the ETP decides to track.

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