NEW YORK (Fabian Capital Management) -- The truth about exchange-traded fund outperformance is that alpha is hard to come by -- and that is a good thing for most investors.
A recent post by Paul Britt of ETF.com talked about how only 15 of 425 U.S. equity strategies have beaten their benchmarks over the last 52-weeks. The article points out that the universe of ETFs they compared were judged according to a similar benchmark and only funds with a statistically significant level of alpha were culled from the list.
However, that statistic may be somewhat misleading, as the majority of ETFs are designed to track a passive index and are therefore going to provide returns (less fees) that are measurably similar to their established basket of stocks. You should actually take comfort in the fact that ETFs are not significantly straying either positively or negatively from their constituent index because that means they are functioning correctly.
The majority of investors that use ETFs prefer them because they provide a level of exposure to a specific segment of the market with minimal embedded expenses. Their growth is continuing to outpace actively managed mutual funds because they deliver a transparent and flexible solution to the need for a diversified investment vehicle that performs as advertised.
While active management can provide a measure of alpha during favorable periods, many studies have confirmed that the majority of active portfolio managers can't demonstrably and repeatedly outperform the market over the long-term. The concern of paying higher fees for weaker performance is just one reason why ETFs have continued to expand, particularly among the lowest cost providers such as Vanguard and Charles Schwab (SCHW).
Despite this stigma, active ETFs have the most potential to outperform their benchmark (i.e. add alpha) when compared to passive indexes. There are currently only 18 U.S.-focused equity ETFs with an active designation according to SEC regulations. That excludes smart-beta and other enhanced indexes that can modify their holdings on a regular basis but are still considered passive vehicles.
In addition, only four on that short list have accumulated assets in excess of $100 million and the First Trust North American Energy Infrastructure (EMLP) is the largest of the group with $780 million. With the exception of a few, the introduction of these vehicles has been met with tepid enthusiasm by investors to date.