Can Active Management Be Indexed?

Ron Rowland:  Regular readers know that I love ETFs. This fairly recent invention has revolutionized investing for millions of people. Now I think we’re entering a new era of innovation.

Why?

Today we’re going to look at some new ETFs, just launched by the venerable Frank Russell Company. Unlike most new offerings, which are simply “me-too” products intended to fill in the sponsor’s product line, the new Russell ETFs do something different … and also restore something we once had but then lost.

Intrigued? Read on …

The Problem with Indexing

The first thing you need to understand is that almost all ETFs are designed to track an index. A few are “actively managed”, but they haven’t really caught on yet. (They will, but that’s another subject.)

The advantage of having ETFs follow an index is that the portfolio is transparent. Everyone knows what is in the index, and therefore (more or less) what is in any ETF that follows it. This is not the case in mutual funds. At best, you’ll get a peek under the hood once a month, and maybe as little as every six months, and almost always with stale data.

The disadvantage of this structure is that most ETF managers have very little discretion. If the index includes some ugly, low-performing stocks, the ETF has to own them anyway.

Some people — the so-called “efficient market” fans — think it is a good thing to handcuff the managers because they’re convinced active managers never add value. They subscribe to the theory that index funds with low expenses are the best investment options no matter the circumstances.

Well, I like index funds, too. But back before ETFs came along, I found success rotating my mutual fund portfolio between the various active equity management styles. Sometimes the “earnings momentum” strategy was best, while other times I would be better off in a “growth at a reasonable price” fund or an “equity income” fund.

Peter Lynch pursued a 'Growth at a Reasonable Price' strategy in the 1980s when he earned his fame running the Fidelity Magellan fund.
Peter Lynch pursued a ‘Growth at a Reasonable Price’ strategy in the 1980s when he earned his fame running the Fidelity Magellan fund.

In the 1990s, mutual fund companies started imposing penalties on what they considered “short-term” investors who doubted the “buy and hold forever” philosophy. ETFs were invented, in part, to resolve this conflict.

It worked pretty well. Dedicated long-term investors stayed in mutual funds that welcomed them. Active investors (like me) started using ETFs that welcomed us.

In the process, however, we active traders lost access to some active equity strategies: Those not easily tied to an index. Now Russell is trying to restore this ability with a slew of new ETFs.

Russell studied many equity managers and found that while their approach to investing was considered active, most of them followed a fairly strict selection process. In fact, they found many strategies strict enough to be defined by rules that could be transformed into indexes that mimic active investment disciplines.

Russell calls these new funds the Investment Discipline Index ETFs. Here’s the complete list:

  • Russell Aggressive Growth ETF (NYSE:AGRG) buys companies expected to have above-average near-term earnings growth. This is often called an earnings momentum strategy.
  • Russell Consistent Growth ETF (NYSE:CONG) focuses on companies with above-average long-term earnings forecasts and consistent historical earnings growth.
  • Russell Growth at a Reasonable Price ETF (NYSE:GRPC) selects stable companies that are moderately priced based on their long-term forecasted earnings growth relative to their price-to-earnings ratio (PEG ratio).
  • Russell Contrarian ETF (NYSE:CNTR) pursues companies that have consistently lagged the market and their sector peers. It tries to identify opportunities for the stock price to improve based on a low historical price-to-sales multiple.
  • Russell Equity Income ETF (NYSE:EQIN) focuses on companies that demonstrate the ability to pay a stable dividend.
  • Russell Low P/E ETF (NYSE:LWPE) buys companies trading at lower price-to-earnings (P/E) multiples relative to their prior level or their sector peers.

The headline in today’s column poses the question of whether or not it is possible to index active management. I believe the answer is yes, if it is “disciplined” active management. “Quant funds” is another way to describe them. However, once the investment style is quantified by a strict set of rules, manager discretion is no longer part of the equation.

This is a big deal — a much bigger deal than most investors realize yet. Word is starting to spread, though. Just last week, I was interviewed by a reporter from Barron’s who had many questions about Russell’s new ETFs.

It may take some time for interest to grow. But once investors and financial advisors realize how useful these ETFs are, they’ll jump aboard quickly. You’ll be way ahead of the crowd if you learn about them now.

Best wishes,

Written By Ron Rowland From Money And Markets

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell, Selene Ceballo, Amber Dakar, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

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