A number of ETF expert podcasts cite the decline of Ark Investment Management’s ARKK as “proof” that active management doesn’t work in the “ETF wrapper” even as the number of traditional active managers launching new ETFs proliferated in 2021.

The truth is that in the value space, many active managers outperformed their benchmarks in 2021. Moreover, since our models at ValuEngine predict a -3% decline for VOO, the Vanguard S&P 500 Index ETF, this might be a propitious environment to shift some core indexed equity to one or more of the active core value ETFs discussed in today’s analysis.

Why? Many active management advocates give three reasons.

1. Active managers have the flexibility and agility to navigate a structural market change away from cap-weighted growth stocks.
2. Value stocks tend to hold up better than growth stocks in this type of inflection point.
3. Active managers generally look to find value in stocks with high earnings quality rather than indiscriminately pick stocks using some value algorithm that a value-themed ETF might choose.

Since very few experts have a particularly good record at market timing or sector rotation, all of the arguments I just made for active ETFs with an underlying value theme may or may not turn out to be true during the next six-to-twelve months. Nevertheless, since my blog generally focuses on comparative ETF analyses, this week’s comparison provides a closer look at a handful of actively managed ETFs with value themes incorporated as part of their fund objective statements.

Image Source: Pixabay

The ETFs included in this analysis are:

DBLV, AdvisorShares DoubleLine Value Equity ETF – The DoubleLine managers try to identify innovative, growth-like stocks selling at reasonable prices, then supplement them in the portfolio with more traditional value-oriented stock picks. One distinguish feature is a solid sell discipline. Holdings are sold if the target price is reached, the investment thesis is disproven, or a better investment is found.

DIVZ, TrueShares Low Volatility Equity Income ETF – Active team has guidelines geared to produce and maintain portfolios that are less volatile with higher dividend yields than the S&P 500. Screens used by the managers also include sustainable growth and high quality as defined by a combination of cash flow, revenue, and capital reinvestment. 

DUSA, Davis Select U.S. Equity ETF - The Davis Capital management team‘s strategy is to purchase securities at a discount to intrinsic value, ideally holding these positions for at least five years to keep turnover low. Its bottom-up approach to the US equity market emphasizes security selection and focuses keenly on the quality of a company’s management, business model, and competitive advantages.

HVAL, ALPS Hillman Active Value ETF – HVAL is an actively-managed fund that will invest in undervalued large-cap companies in the US with perceived competitive advantages. The fund’s management team uses a screening process that begins with building and maintaining a proprietary qualified investment universe based on its qualitative analysis of each company emphasizing industry dominance, management prowess, pricing and purchasing power, competitive advantages, financial flexibility, product and services quality, and brand value. This universe is then screened with 3 value metrics: discounted cash flow, price-to-book ratio, and price-to-sales ratio.

VALQ, American Century STOXX U.S. Quality Value ETF – My inclusion of this Quality Value ETF by American Century is a bit of a stretch. Although American Century has since launched actively managed ETFs using a semitransparent structure, VALQ was launched before the ETF Rule and semi-transparent trading baskets were made available to active managers. In order to launch their this ETF, they created a detailed and complicated algorithm that simulated their active management process that focused on quality and value. The resulting index used by the fund’s management team is provided by a STOXX custom index made to American Century’s specifications. 

When the word “passive” is used to describe a product such as VALQ, it is so inappropriate that it makes me laugh. Here’s a description of the index methodology constructed to emulate the manager’s active process. A single perusal will disclose that all the research, monitoring, and changes that go into this American Century fund make it anything but “passive.”It’s simply an automated active manager. The prospectus even allows for oversight changes when needed.

“the fund’s underlying index is actually comprised of two separate indexes: one value-focused and the other income-focused. Both sub-indexes begin with a universe of the 900 largest companies in the US. To weed out low-quality securities, the sub-indexes assess each company for profitability, earnings quality, management, and earnings revisions. Securities that score in the lower part of the quality spectrum are excluded. The value index scores securities on valuation metrics such as earnings yield and cash flow, while the income index scores securities on dividend growth, yield, and sustainability. The final portfolio allocation to value and income is determined by a momentum-based optimization model. What is left is a broad portfolio of large- and mid-cap US securities that are undervalued or have sustainable income. The index is rebalanced monthly and reconstituted quarterly.”

This is my explanation as to why I included VALQ in this review of actively managed value and quality ETFs.It also stood out to me because our models rank it a 5 (Strong Buy) and none of the other value ETFs included in the study earned a VE rating higher than 2 (Sell) as calculated by our models.

The table below lists data in pertinent categories for these for ETFs IWD, the Russell 1000 Value Index, is the main comparison as an appropriate benchmark. VOO is also included for reference.

Key Findings:

1.  What a difference four weeks can make! Four weeks ago, the S&P 500 ETFs outperformed the vast majority of the ETFs analyzed in this column and almost thing else other than the Nasdaq. This is no longer the case. Not only did the S&P 500 suffer nearly a 7% loss in January but its 12-month rolling return lost its lights-out month of January 2021. 

2. The actively managed ETF portfolios in this selection are all more concentrated in terms of number of positions when compared with institutional portfolios. The low is the 28 positions in the Davis Advisors’ DUSA and the high side is the 51 positions held by DoubleLine’s DBLV.   

3. HVAL, ALPS Hillman Active Value ETF – has about 6 months of historical performance and generally would not be included in my ETF comparative reports. It caught my eye for two reasons. The first is that it had the highest one-month return of any entrant in this category in the ETF.com database. The second is that it brought veteran portfolio manager Mark Hillman of renowned investment boutique Hillman Capital into the ETF marketplace. Another bonus is that it’s 0.51% expense ratio is below average for actively managed ETFs. Due to its short history, HVAL has no ValuEngine rating.

4. DIVZ, TrueShares Low Volatility Equity Income ETF – did exactly what the name said it would do in its first year of existence and more. It provided the highest dividend income per share (3.7% dividend yield) with the lowest volatility (Standard deviation of 12.2%, Beta of 0.58) of any of its peers.

The unexpected benefits in 2021 was that portfolio manager Jordan Waldrep’s fund outperformed just about every industry-diversified ETF without short-selling and/or derivatives exposure during the past three months with a +4.8% return as compared with the tough-to-beat -0.8% posted by the iShares Russell 1000 Value ETF, IWD and the stunning 6.1% loss incurred by S&P 500 ETF VOO.

At ValuEngine we do not expect the outperformance benefits to continue as DIVZ has our lowest rating of 1 (Strong Sell) for price performance. Constituent-wise, I consider it the antithesis of ARKK (long-short traders may wish to take note). Most of the top 10 holdings resemble a roll call for the global titans of the 1980s: Exxon Mobil, Chevron, Union Pacific; Philip Morris (and new incarnation Altria); Devon Energy; AT & T; Verizon; Philip Morris; and United Health Care. This portfolio is not poised to outperform in a normal upward-sloping market. It proved to be great, however, as a safe harbor for income-oriented investors desiring low volatility. Its 65-basis-point (0.65%) fee is about average for actively managed ETFs.

5. DBLV, AdvisorShares DoubleLine Value Equity ETF preceded Hillman by several years in bringing a highly followed portfolio manager, Emidio Checcone with an iconic asset management company, DoubleLine Group into the ETF space, in 2018 to be exact. In this case, Checcone’s team took over an existing AdvisorShares’ fund in need of revitalization. 

The fund has consistently performed very well, beating its Russell 1000 Value benchmark ETF, IWD, handily during the past 3-year, 1-year, and 1-month periods while virtually tying it for the 30month period. I find it particularly remarkable that DBLV is now 80 basis points (0.80%) ahead of IWD in annualized price appreciation for the 5-year period ending last Friday because the management team that was replaced had underperformed its bogey by more than 250 basis points (2.50%). Currently, DBLV has our lowest ValuEngine rating of 1 (Strong Sell). This is a rare case where I will personally disagree with our models. 

In the choppy seas we predict to lie ahead for the stock market, a proven active management team with a time-tested and fundamentally sound value strategy to capture growth at reasonable prices greatly interests me. The fund has performed well in favorable and unfavorable environments for value investors. The biggest downside I see to DBLV is that it has a very high fee, 0.91%. That would weigh against it more from my perspective if it hadn’t done such a consistent job thus far of earning its fee each year.

6. DUSA, Davis Select U.S. Equity ETF, has been a personal favorite since its inception in 2017. I had been publishing articles and columns advocating for traditional active managers to use the ETF structure since a published article in a Dow Jones Journal in 2001; the structure is not only more tax-efficient but frees the investment manager from daily cash flows so that all trades are done for investment reasons, not liquidations. Davis Advisors was, as far as I know, the first major mutual fund family, led by Founder Christopher Davis, to understand that this was in the best interests of his fund shareholders and to take the plunge. Davis looks to identify companies with above-average growth potential selling at a discount to intrinsic value, determined both quantitatively and qualitatively after painstaking bottom-up research. Yet another variation on the Growth-at-Reasonable-Prices theme, this approach is geared to focus on about 30 holdings that the fund expects to hold for five years or more. 

Looking back at our ETF comparison table, DUSA is another actively managed ETF that has done a good job of meeting its stated objectives. On a performance basis, it has been a star among actively managed value ETFs with a 5-year annualized price return of 12.8% as compared with 7.5% for benchmark ETF, IWD based upon the Russell 1000 Value Index. Using traditional value ratios, DUSA has the lowest Price/Book and Price/Earnings ratios relative to its peers and the benchmark by a very wide margin. Indeed, the P/E of 12.8 struck me as so low for a fund that has generated strong returns in this market that I had to check it twice to make sure I was being accurate. Its forward P/E is only 10.8 according to its website. Its expense ratio of 0.62% is slightly below average for actively managed ETFs.Again, thus far it has earned its fees in outperformance. My one disappointment is that we have not received all the DUSA data we need in our recent feed, so we have no VE rating on it.I hope to rectify that soon.

7. VALQ, American Century STOXX U.S. Quality Value ETF, is algorithmically managed to simulate an active strategy as detailed above. As such it makes an appropriate benchmark for active managers seeking to provide value and performance using a growth-at-reasonable-prices approach. It has our highest ValuEngine rating of 5 (Strong Buy) for anticipated price performance. Its past performance on the table has been less than impressive but statistically mean reversion is a positive contributor among the many factors our dynamic models tend to consider. Another positive indicator I see in the table is the highest percentage of undervalued stocks, nearly 60%, in its current portfolio. On a position-weighted average, its P/E ratio of 16.3 is extremely reasonable, more than 5 points lower than the 21.4 P/E of IWD. These facts combined with its recent price tumble might explain why our models believe VALQ to provide above-average price performance in the months ahead.

8. Whether tested against Russell 1000 Value benchmark index ETF IWD or simulated actively managed VALQ from American Century, the four truly actively managed ETFs have certainly held up well in comparison since inception. In the case of HVAL, it’s too soon to tell. I’d call it an ETF to monitor at this time. 

Although it’s just barely more than one year old, Jordan Waldrep and his management team at DIVZ have convinced me that it will continue to meet its twin objectives of providing strong dividend yields with low volatility on a fairly dependable basis. Typically, retirees tend to be less concerned with capital appreciation than their needs for income and stable returns. This ETF that tends to hold mature and fundamentally sound companies seems like a very appropriate choice for such investors.

9. Since our ValuEngine models are based upon the undeniable truth that timing is everything, VALQ, rated 5 (Strong Buy) is our choice for best price appreciation in the next three-to-six months. It is a solidly constructed fund that seems well poised for a good run. Its 29-basis point management fee is quite reasonable considering its intricate methodology well-designed by the American Century fund management team.

10. DBLV and DUSA both have well-established management teams and asset management companies behind them. Both have above-average performance records with highly desired value characteristics that favor quality over dividend yield.In fact, I’d characterize DUSA’s record and accompanying value characteristic as well above average. The expense ratios reinforce the fact that active management from established managers still commands higher fees with only DBLV’s being above average in this category. Despite its currently lowest ValuEngine rating, DBLV is a solid choice for those investors who want both growth and stability and prefer active management to momentum-heavy index funds.I find the case for DUSA as a buy-and-hold investor’s core active management holding even more compelling. 

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My major point to commentators such as Eric Balchunas, Nate Geraci, Todd Rosenbluth, Ron DeLegge, Dave Nadig, Robin Powell, and others is to give active management in the ETF structure time to establish itself. Results in the value space are more than competitive for the few early entrants that have a track record of five years or more such as DUSA and DBLV. I analyzed another actively managed ETF a few weeks ago that is quality-focused, so it wasn’t included in this value-focused analysis. It was TTAC, now renamed the FCF Managed Quality ETF, managed by Bob Shea, and its performance as compared with its benchmark index ETF had also been impressive. Note that FCF stands for Free Cash Flow as Trim Tabs has now rebranded to FCF for its asset management products.

I realize that a handful of active management products, half of which have less than $100 million under management, doesn’t prove very much beyond the fact that it is possible for active management to outperform and/or perform competitively with index funds even on an after-fee and after-tax basis. More to the point, it is mathematically and operationally deterministic that an active management team with the same objectives will perform better on an after-tax and after-fee basis in the ETF structure than in the traditional daily-cash-redemption model. 

I emphasize the fact that the ETF structural advantages benefit the fund manager’s returns and the fund shareholder far more than the “wrapper” term would indicate. Since the fund doesn’t need to make daily cash redemptions, no liquidation need be made on the basis of embedded capital gains. This is huge. All active trades are made SOLELY on the basis of investment decisions, and this also eliminates the cash drag factor. For more, please read my article “Leveling the Playing Field for Active Managers”, detailing all the advantages and efficiencies of migrating from the traditional structure to the ETF structure. It should be considered a best-practices requirement. For years, the missing link for active managers was the ability to shield their funds from the impact costs of having their trades front-run by hedge funds. There are now three SEC-approved structures that protect the funds from this problem. The most efficient of the three is Shielded Alpha by Blue Tractor as discussed in the same paper. For more about the front-running problem, click here.

Most of the experts mentioned above quote excellent research by SPIVA (S&P Index vs. Active) detailing the historical futility that actively managed funds have in trying to beat the index. As a quant, I have cited them many times myself and have most of my own retirement money in core index funds. However, I have shifted a small portion to DUSA and to JEPI (an active JP Morgan fund not covered here but somewhat similar to DIVZ). I have shown mathematically using Monte Carlo methods that the consistent 75%+ underperformance by actively managed funds could not be caused by stock selection. In the aggregate, 2000+ active managers cannot be that much worse than random. It is the traditional daily-cash-redemption structure that is responsible. 

Therefore, I suggest strongly to SPIVA that they consider issuing a new series of reports comparing actively managed ETFs to SPY, the largest S&P 500 ETF. That provides for a level playing field and fair “apples vs. apples” comparisons. 

In conclusion, I’ve now provided empirical examples that active managers can beat index ETFs, even after fees, using the ETF structure. I’ve also detailed extensively in examining the causes of structural underperformance that it is highly probable that this handful of available examples of actively managed core ETFs are not fluky outliers. Going forward, as more active managers provide sufficient history for study, it is far more likely that the number of active managers that underperform consistently after fees be much closer to 50%.To paraphrase James Carville, the reason so many traditional active managers fail to deliver competitive returns with the index is not stock selection, “It’s the structure, Stupid!”