ESG ETFs Help Investment Portfolio’s Conform to Investors’ Attitudes

As many seek to diversify their equity portfolios, consider a sustainable investing exchange traded fund strategy that locks on the potential benefits of environmental, social and governance, or ESG, principles.

On the recent webcast (CE Credit available on-demand), The Untapped Potential of ESG Investing, Sharon French, Head of Beta Solutions at OppenheimerFunds, explained that there is growing demand for ESG investments in response to rising standards for corporate business practices, demographic shifts and investing preferences, regulatory and policy developments, global sustainability challenges, and greater accessibility and proliferation of ESG data.

Meanwhile, French mentioned that corporate business practices are changing as well to meet the shifting demand for more socially responsible investments. For example, more companies are reporting impact investing and social responsibility data as there is a growing body of research on the potential impact of ESG investing.

Among the various investor groups, the rising affluent millennial investor are showing a significant change in investment behavior, compared to their older counterparts. French pointed out that millennials are more likely to be interested in responsible investing than other generations, indicated they would like to work for an employer that makes a positive social impact and like investments with competitive returns that also promote positive social and environmental outcomes.

Financial advisors will undoubtedly be closely monitoring this rising group of investors as $30 trillion in wealth is expected to transfer from the Baby Boomer generation to their heirs.

“It’s important to recognize the critical role that Affluent Millennials will play,” French said. “They will eventually be put in charge of the family portfolios. Many of them plan to increase their allocations towards impact investing, which looks to provide societal or environmental benefits in addition to sustainable investment returns.”

Matthew C. Straut, Head of Registered Investment Advisor Channel at OppenheimerFunds, also argued that the millennial investor may have a much different investment mindset to older generations. For example, millennials are more likely to pull money away from companies that use animal testing, use tax minimization schemes and are in the news for wrong reasons. In contrast, those aged 36 or older are more likely to pull money away from companies linked to repressive regimes and associated with the pron/sex industry.

Michael Venuto, Co-Founder and CIO at Toroso Investments, has seen a shift in financial advisors’ perspective toward a more holistic investment management process. Venuto pointed out that popularity and conversations centered around ESG investing are accelerating among advisors and clients.

“ESG data and policies are here to stay and may become the norm for investment analysis and sere as indicators of future performance,” Venuto said.

In survey of financial advisors attending the webcast, 50% of respondents expect ESG strategies to enhance return over time, but 47% still require further education on the subject, which suggest that many are at least looking at the investment theme. About 55% of respondents also indicated that they expect to increase exposure to ESG strategies over the next 12 months while 45% expect to keep current holdings steady.

Vincent T. Lowry, Lead Portfolio Manager of OppenheimerFunds’ Revenue Weighted Strategies, laid out two two recently launched ESG ETFs – the Oppenheimer ESG Revenue ETF (NYSEArca: ESGL) and Oppenheimer Global ESG Revenue ETF (NYSEArca: ESGF) – for investors looking to target companies with sound ESG principles.

Specifically, ESGL targets broad U.S. large-caps through the S&P 500 but screens through Sustainalyics’ proprietary scoring system that focuses on those with positive ESG attributes and employs a revenue-weighted methodology.

ESGF, on the other hand, takes a global approach. The ETF tries to outperform the MSCI All Country World Index with strong ESG practices and re-weights companies based on revenue earned. MSCI ESG Research utilizes a proprietary ESG scoring system and screens companies based on Sharpe Ratio, a measure of risk-adjusted performance.

Source: Etftrends

This figure helps explain why so many active ETF managers underperform

Are your active funds active enough?

Non-passive funds—where the components are chosen by a team or through a rules-based system, rather than simply tracking a benchmark—have fallen out of favor in recent years, with investors instead gravitating toward funds that are cheaper, easier to understand, and which never underperform.

Another factor keeping investors from embracing them? These active funds may, in fact, be too passive.

A key metric for evaluating mutual funds and exchange-traded funds underlines why active and “smart beta” products have seen far less adoption than their passive equivalents: active share, or the degree to which the holdings of a non-passive product overlap with its closest benchmark (for example, an active large-cap U.S. equity fund compared with the S&P 500 SPX, -0.20%

If an active or smart-beta fund has a low active share, either by holding the same securities or having similar allocations to its benchmark, then it will have a high correlation with that index. (For this reason, portfolio managers with low levels of active share are frequently referred to as “closet indexers.”) This limits the fund’s potential for outperformance, especially after fees are taken into account.

If investors are able to get similar performance for a cheaper fee, it’s hard for an adviser to advocate for a nonpassive product instead. In fact, data has shown that an overwhelming number of active funds underperform over the long term, as do smart-beta funds.

This could be a reason why active and smart-beta funds have seen comparably less interest. Thus far this year, $5.28 billion has flowed into active ETFs, according to Morningstar data, while $41.2 billion has gone into smart beta, which Morningstar refers to as “strategic beta.” More than $223 billion has gone into passive ETFs.

“There’s a bit of research that shows if you don’t have at least 80% active share, then it’s unlikely that you will outperform after fees,” said Andrew Slimmon, a managing director at Morgan Stanley Investment Management, where he is the lead senior portfolio manager on all long equity strategies for Applied Equity Advisors. Referring to the active managers who notably outperform, he said “the key issue is that they have more dispersion to the index.”

Passive strategies are particularly strong in periods of robust economic growth, when the market’s gains are broad based. Active managers tend to perform better in periods of volatility, as in the third quarter of this year, when 53% of active managers outperformed their benchmark, according to data from J.P. Morgan. That quarter was marked by post-Brexit volatility, as well as uncertainty going into the U.S. election. Because of events like that, Candace Browning, the head of BofA Merrill Lynch Global Research, recently wrote that “2017 could be the year of the active investor.”

Of course, high active share cuts both ways. Assuming a fund doesn’t frequently change its holdings en masse, it will go through periods when its strategy is in vogue, allowing it to outperform, as well as through periods where it is out of sync with the market cycle, leading to underperformance.

“Active share does not mean outperformance. What it means is the potential to outperform,” said Michael Venuto, chief investment officer at Toroso Investments. “No active share means no outperformance, guaranteed. If you have it, then you at least have the potential.”

Venuto uses active share calculations in researching prospective funds to invest in. As an example, he compared the PowerShares Exchange Traded Fund FTSE RAFI US 1000 Portfolio PRF, -0.25% —a large-cap equity fund—with the SPDR S&P 500 ETF Trust SPY, -0.22% which tracks the S&P 500. The two funds have an overlap of 70%, per his calculations, but while the PowerShares fund comes with an expense ratio of 0.39%, the SPDR fund has a fee of 0.09%.

“For that 70%, I should only spend what it costs to get the S&P,” he said. “Therefore, you’re basically paying 30 basis points for the remaining 30%—for the active share. That would be like paying 90 basis points for the fund overall, and I do not feel that there’s enough difference in the active share to justify that expense ratio. This isn’t the only thing I’d look at here, but this alone is definitely enough to deter me from the product.”

Venuto’s calculations were derived from software his firm developed. Invesco, which manages the PowerShares family of ETFs, didn’t immediately return requests for comment.

The average expense ratio for a U.S. smart-beta ETF is 0.356%, according to Morningstar. For a passive fund, it is 0.344%, although many of the most popular offer ratios below 0.1%, and analysts view the passive industry as being in a “race to zero.” Active ETFs that cover U.S. stocks have an average fee of 0.864%.

For a large-cap equity fund that justifies its expense ratio, Venuto cited the Direxion All Cap Insider Sentiment KNOW, -0.05% which has a fee of 0.65% but only a 14% overlap with the S&P 500. “The overlap is so low that the ‘smart’ portion of the portfolio is equal to the expense ratio. What you pay coincides with what you should actually pay.”

He added that in a case like this, he would also research the fund’s strategy, tradability, and spreads before investing.

The problem with active share is that it is difficult to calculate—especially for mutual funds, which don’t disclose their holdings daily, unlike ETFs.

Dave Nadig, the chief executive officer of ETF.com, an ETF research and analytics firm, said he was of “a mixed mind” about using active share as a guiding principle.

“I’m a skeptic for people leaning too hard on it, as it is challenging to calculate and because it doesn’t predict performance so much as increase the risk for a higher dispersion of performance,” he said. “That said, if you want outperformance, a high-fee low-active manager is not going to give you what you’re looking for. You’d basically be buying an expensive index.”

Source: marketwatch

KNOW Characteristics: Finding the Right Factors

In this paper we will explore the evolution of smart beta investing through the advent of academic factor investing and examine how the characteristics sought by the SBRQAM Index can potentially overweight and/or rotate through the most common factors contributing to competitive performance.

The Sabrient Multi-cap Inside/Analyst Quant-Weighted Index (SBRQAM), is an index that investors can obtain exposure to through the Direxion All Cap Insider Sentiment Shares ETF (ticker: KNOW). For the most recent quarter end performance of the Fund, please see the disclosure page.

Read More

Portfolio X-Ray: Toroso’s Neutral Allocation Strategy

by Cinthia Murphy

There is no single recipe to building an ETF portfolio. But understanding how a portfolio is built is key to picking the right one. And choices certainly abound, with hundreds of ETF strategist portfolios commanding nearly $100 billion in combined assets today.

For that reason, we are setting out to better understand how ETF strategists go about creating these portfolios in a series of interviews that look under the hood of some of the ETF portfolios available to retail, institutional and advisor clients alike.

Today’s Portfolio: The Toroso Neutral Allocation Strategy

Provider: Toroso Investments, New York City

Who We Talked To: Mike Venuto, Chief Investment Officer and Co-founder

Portfolio AUM: Firm’s assets under management is $78 million as of end of April; the portfolio AUM is commingled.

Primary Goal: The Toroso Neutral Allocation Strategy strives to outpace inflation by providing a consistent absolute return with limited volatility. The main goal of the strategy is to preserve wealth as a core allocation during the accumulation and distribution phases of an investor’s life cycle.

What sets this strategy apart is its approach. Toroso’s “investing glide path” is different from traditional modern portfolio theory risk-based allocations. The firm uses goals-based portfolios, targeting each individual client’s time horizon and risk tolerance with various combinations of asset allocations. The three primary investor goals include growth, income and wealth preservation.

Methodology: The strategy uses a combination of alternative asset allocation and in-depth fundamental ETF selection. The asset allocation is based on Harry Browne’s permanent portfolio allocation, “which has historically provided returns of about 8% with one-third of the volatility of U.S. equities.”

The allocation is predicated on equal weighting of four asset classes—25% per asset class: equities; commodities and other alternatives; cash equivalents; and bonds that “thrive in one of four possible economic environments: prosperity, inflation, recession and deflation.”

The second component of the portfolio construction is in-depth fundamental ETF selection. Toroso uses only ETFs, and tries to find themes that provide excess returns relative to the core benchmarks that represent each asset category. Toroso evaluates passive ETF ownership, smart-beta cost and active share, valuations, index construction and growth metrics.

Target Client: The strategy is available to institutional investors and as a managed account on a variety of platforms, including Schwab, TD Ameritrade and certain Pershing platforms. The strategy is designed for individuals or financial advisors looking to preserve wealth and compound returns. Generally, this is not a total portfolio solution, but rather a core component to complement additional growth or income strategies.

Asset Allocation Breakdown:

25% Equities

25% Bonds

25% Cash/Cash equivalents

25% Commodities/Alternatives

All ETFs? Yes

Portfolio Holdings:

Prosperity 25%

BioShares Biotechnology Clinical Trials Fund (BBC)

Oppenheimer Mid Cap Revenue ETF (RWK | C-79)

Vanguard Total Stock Market Index Fund (VTI | A-100)

VelocityShares Daily Inverse VIX Medium-Term ETN (ZIV)

Recession 25%

Guggenheim Enhanced Short Duration ETF (GSY | B)

iShares 1-3 Year Treasury Bond ETF (SHY | A-97)

Inflation 25%

AdvisorShares Gartman Gold/EURO ETF (GEUR | D)

SPDR Gold Trust (GLD | A-100)

Credit Suisse X-Links Gold Shares Covered Call ETN (GLDI | F-41)

Deflation 25%

iShares Core U.S. Aggregate Bond ETF (AGG | A-98)

PowerShares Build America Bond Portfolio (BAB | B-61)

iShares 7-10 Year Treasury Bond ETF (IEF | A-55)

Fees: ETF average total expense ratio is 0.23%

The Toroso management fee is determined based on the platform or custodian the client selects or that their advisor uses. The maximum fee for a direct client is 1.00%. Generally, the fee for a dual contract through a wealth advisor is 0.35%, and the fee for a retirement-advisor-supported 401(k) plan is 0.40%.

Performance (YTD or 1 Year): Year-to-date net-of-fee performance through May 31 is 3.87%

Source: ETF

The Antidote for Volatile Times: Disciplined & Rigorous Security Selection

Now and Then…

With over one third of 2016 behind us, the markets have offered little to be excited about in terms of returns. We have seen some massive drawdowns in the US and Developed markets and some equally strong recoveries. In previous commentaries, we have proposed that the US equity market is fundamentally overvalued unless further government-sponsored stimulus is applied. It now appears that not only is future stimulus unlikely, but further monetary tightening is probable this summer. So with that realization, volatility is expected for the market.

Although this is exactly what we expected at the beginning of the year, the violent recoveries and low level of implied volatility have been a surprise. (Do you remember the phrase “irrational exuberance”?) We maintain our commitment to diversification and protection of wealth in what we believe will be an increasingly volatile environment. Additionally, we continue to seek fundamentally sound investments, through our rigorous security selection process, which will be the main subject of this commentary.

So How Have We Done?

In past commentaries we have noted that this year diversification is working. Asset class correlation has normalized and we are no longer in an environment where everything goes up and/or down together. This has substantially benefited our flagship wealth preservation strategy. The Toroso Neutral Portfolio was up 4.6% net of fees through April 30th, with limited volatility. Our income strategy has also navigated the choppy waters well; the Toroso Target 5% Income Portfolio was up 2.5% net of fees through April 30th, while maintaining a consistent annualized yield of 5.1%.

Unfortunately, our two growth strategies are underperforming year to date and have been negatively affected by the markets irrational optimism. The Toroso Sector Opportunity Portfolio was down -2.2% through April 30th, mainly because our volatility hedge detracted from returns during the rally in March. Often referred to as the price of insurance. The Toroso Global Alpha Portfolio was down -0.6% through April 30th, which can be attributed, again, to hedges imbedded in the ETFs we utilize. However, we remain confident that the portfolios are positioned well, for the volatile markets ahead, with fundamentally attractive securities.

What We Do

When we started Toroso in 2012, one of our main goals was to provide thoughtful ETF research and advice on ETF security selection that could be as comprehensive as what active managers commit to individual equities. Over the past few years we have developed software tools and processes to dig deeper into the key ETF behaviors and statistics; such as fundamentals, true cost, ownership or passive influence, premium or discount to NAV, performance ratios, risk metrics and index construction.

Our security selection process begins with the benchmarks embedded in our asset allocation, then we seek out themes and other qualitative concepts that may enhance the core benchmark exposure, and finally we refine those ideas through quantitative data using our proprietary software tools and processes. In this commentary we want to share two examples of how these qualitative and quantitative processes work.

Is this Porridge Too Hot?

We have continually discussed the current and anticipated volatility of the US equity markets this year. With that in mind, an obvious qualitative candidate for inclusion in our portfolios are ETFs focused on minimum volatility. Apparently, we are not alone in this desire to protect against volatility; the iShares MSCI USA Minimum Volatility ETF (USMV) has seen substantial inflows this year.

In the year-to-date period through April 29, the iShares MSCI USA Minimum Volatility ETF (USMV | A-71) has taken in $4.7 billion in investor capital, second only to $6.2 billion for GLD, according to FactSet data. … As the name suggests, the fund aims to minimize the volatility of its portfolio. It does this by holding a basket of stocks that together have low-volatility characteristics. Unlike the competing PowerShares S&P 500 Low Volatility ETF (SPLV | A-58)—which simply holds the 100 least volatile stocks in the S&P 500— USMV considers the correlations between various stocks to come up with its optimized mix.”
ETF.com May 3, 2016

On its face, this ETF appears to be the perfect candidate to solve for the macro-economic problem we have been describing all year. We conducted our quantitative process to evaluate the position and, in our opinion, discovered it is not the right ETF to limit volatility. Sometimes a rigorous security selection process benefits a portfolio by avoiding a potentially disastrous investment rather than finding a superior one. That is the case with USMV and here are three concerns our research shows:

  1. Fundamentally Overvalued – Much of the market volatility stems from the belief that interest will rise; in a rising rate environment P/Es tend to contract. The P/E of USMV is 20.1 or at a higher level than the S&P 500 (SPY) at 17.8 and even more frightening higher than the US Growth (IVW) at 19.7. Put simply, can a fundamentally overvalued portfolio lower volatility when the market corrects?
  2. The Herd Creates Bubbles – On average, ETFs own about 4.6% of every US public equity. On average, the names in USMV are 5.6% owned by ETFs. When passive ownership creeps above normal levels we have found this to indicate a brewing bubble. Similar metrics were present with REITs in 2013 and with MLPs in 2015. Also, the top position in the ETF is Newmont Mining (NEM), which is also a top position in the Gold Miners ETF (GDX). GDX and NEM are extremely volatile and many holdings like this appear counterintuitive for USMV.
  3. Factor Contradiction – The chart below compares USMV to other ETFs with the most overlap of holdings by weight. How is it possible that an ETF focused on Minimum Volatility can have so much overlap with an ETF focused on Quality Factors, an ETF focused on Momentum factors and a Mega Cap ETF, which is, essentially, a size factor? The answer lies in the ETF.com quote above; “USMV uses optimizations and other constraints to build the portfolio and limit tracking error.” Our fear is that the end result is a portfolio that appears minimum volatility in good markets but may not provide any protection in a true downturn.

This analysis of USMV shows how our security selection process can help avoid ETFs that qualitatively meet our investment objective but quantitatively are rejected.

This Porridge is Just Right

Now for an example of an ETF that meets both our qualitative and quantitative criteria. The Direxion Insider Sentiment ETF (KNOW) has been a core exposure in the Toroso Global Alpha portfolio for a few years. Our original thesis focused on the historical outperformance of companies that have elevated levels of disclosed insider buying. At time of initial purchase, the fundamentals were in line with the benchmark and the active-share generated versus the S&P 1500 was 89%, thereby meeting our quantitative requirements. (Active-share refers to the percentage of the ETF that is considered different than the benchmark to which it is compared.) KNOW has been a successful investment that we continue to evaluate and research.

That research has led us to evaluate another aspect of KNOW that is consistent with other Environment, Social and Governance (ESG) themes we are researching. The index behind KNOW does two characteristic based screens of the S&P 1500 universe. The first is a forensic accounting screen to help avoid fraud and other malfeasance, the second looks for companies where the insiders/management are personally investing in the company.

These two characteristics represent core concepts behind the G in ESG. Strong corporate governance has historically been an ESG factor that can benefit the performance of securities, but more importantly avoiding companies with accounting irregularities can help lower volatility during bear markets. Remember in 2008, many of the now bankrupts mega cap companies practiced creative accounting (There was a movie made about one!).

We have continued to add to our KNOW position as our attention has turned to more defensive positions to combat volatility. The fundamentals remain attractive with a P/E of 16.7 and an active-share that is now 90%.

Why We Do It

The well-known and often cited 1991 study by Gary Brinson, Brian Singer, and Gilbert Beebower titled Determinants of Portfolio Performance shows that asset allocation accounts for as much as 91% of the average investor’s returns. This and other studies are based on replacing benchmarks with active managers and are somewhat antiquated to the ways investing with ETFs is done today. We believe that when it comes to building portfolios of ETFs, a rigorous security selection process can have a much more meaningful attribution for three reasons:

  1. Passive ETFs, like KNOW, can provide superior returns, meaningful coverage of characteristics likely to limit downside volatility, and impactful ESG exposure.
  2. The security selection process can force the discovery of bubbles like REITs, MLPS or Minimum Volatility. These quantitative revelations have helped us adjust our asset allocation away from irrationally valued assets.
  3. The data and resources available to evaluate ETFs are still quite limited thereby generating inefficiencies in pricing and valuation. Our proprietary software was built to aid in uncovering these inefficiencies.

table

The ETF landscape continues to grow and offer new problems and solutions. Toroso remains committed to outcome oriented asset allocations enhanced by our disciplined research and rigorous security selection.

Disclaimer — This commentary is distributed for informational and educational purposes only and is not intended to constitute legal, tax, accounting or investment advice. Nothing in this commentary constitutes an offer to sell or a solicitation of an offer to buy any security or service and any securities discussed are presented for illustration purposes only. It should not be assumed that any securities discussed herein were or will prove to be profitable, or that investment recommendations made by Toroso Investments, LLC will be profitable or will equal the investment performance of any securities discussed. Furthermore, investments or strategies discussed may not be suitable for all investors and nothing herein should be considered a recommendation to purchase or sell any particular security. Investors should make their own investment decisions based on their specific investment objectives and financial circumstances and are encouraged to seek professional advice before making any decisions. While Toroso Investments, LLC has gathered the information presented from sources that it believes to be reliable, Toroso cannot guarantee the accuracy or completeness of the information presented and the information presented should not be relied upon as such. Any opinions expressed in this commentary are Toroso’s current opinions and do not reflect the opinions of any affiliates. Furthermore, all opinions are current only as of the time made and are subject to change without notice. Toroso does not have any obligation to provide revised opinions in the event of changed circumstances. All investment strategies and investments involve risk of loss and nothing within this commentary should be construed as a guarantee of any specific outcome or profit. Securities discussed in this commentary and the accompanying chart, if any, were selected for presentation because they serve as relevant examples of the respective points being made throughout the commentary. Some, but not all, of the securities presented are currently or were previously held in advisory client accounts of Toroso and the securities presented do not represent all of the securities previously or currently purchased, sold or recommended to Toroso’s advisory clients. Upon request, Toroso will furnish a list of all recommendations made by Toroso within the immediately preceding period of one year.

ETF Reference – Mike Venuto Provides ETF Q&A

ETF Reference – Mike Venuto Provides ETF Q&A

The editorial team at ETF Reference surveyed 57 ETF investing experts, including Toroso’s Mike Venuto, in search of the best tips for exchange-traded fund investors. The response received was incredible. The panel of experts sent the editorial team hundreds of amazing tips! They winnowed that list down to 101, which can be accessed from Toroso’s Q&A interview. Whether you’re a beginner or a veteran ETF investor, there are likely dozens of valuable tips in there for you.

Toroso was humbled and excited to be a part of such an elite group of experts. Obviously, some of our contributions were cut in the editorial process to make room for ideas from the other professionals. However, we thought it would be nice to share all of our answers, so we have provided in the link above the written Q&A interview we contributed to ETF Reference on behalf of Toroso.

World of ETF Investing – New York

LEARN THE EXPERTS’ BEST STRATEGIES FOR PROFIT

Attend and and receive comprehensive ETF education from top experts who will discuss the hottest topics in the industry today. Take home expert insights for selecting the best ETFs, learn how to find opportunities around the globe, and get an understanding from top financial advisors about the best ways to use ETFs as part of your portfolio strategy.

Venue
The New York Stock Exchange

Nov 06, 2015
10:00am to 6:00pm

Event Link

Liquid Alternative Strategies East Conference – New York

MIKE VENUTO IS SPEAKING AT THE LIQUID ALTERNATIVE STRATEGIES EAST CONFERENCE IN NEW YORK
Panel Discussion on:

Liquid Alt and ETF Options on 401(k) Plans – Understating New Product Offerings

  • Obstacles to getting new products onto a 401k menu
  • Do investors understand the offerings
  • Custodial and record keeping mandates

Venue
The Westin Times Square, New York, NY

Oct 05, 2015 – Oct 06, 2015

Event Link

PODCAST – Michael Venuto Provides Updates on Toroso’s Wealth Preservation Strategies, Income Strategies, and Growth Strategies

PODCAST – Michael Venuto Provides Updates on Toroso’s Wealth Preservation Strategies, Income Strategies, and Growth Strategies

Listen to a brief update on how investment strategies managed by Toroso are handling the volatile markets that we are experiencing today.  Low interest rates, low inflation, no wage growth are all having an impact, and a well-diversified, outcomes based strategy is required.

The “Smart Beta” Way to 401(k) Investing

The “Smart Beta” Way to 401(k) Investing

The advent of “smart beta” strategies provides an opportunity for ETFs to provide enhanced goals-based solutions for 401(k) investors.  However, this is not as simple as replacing expensive active management with intelligent ETFs. Read about Toroso’s approach to goals oriented investing for 401(k) plans using ETF strategies.