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Written by: Shiv Patel | Advisor Asset Management
Traditional, passive exchange-traded funds (ETFs) are those that are built to track a comprehensive, broad market index. Driven by their underlying index criteria, passive ETFs construct portfolios as dictated by their underlying indices to closely mirror their investment results. However, index construction has long evolved from the days of simple, broad, market-cap criteria. Many indices today are designed around a specific — and at times intricate — set of selection criteria. As a result, many index-based ETFs can offer meaningful degrees of active management, as measured by active share, relative to their more traditionally constructed passive benchmarks.
“Active share” is the percentage of a portfolio’s holdings that diverge from its benchmark. More specifically, it’s based on the weightings of a portfolio’s investments compared to those in its benchmark and can be a good indication of the level of active management attained.
To illustrate, take the S&P 500 Index itself: widely regarded as the single best gauge of the U.S. equity market. It too has an even broader benchmark, the S&P Total Market Index, which consists of all eligible U.S. common equities, ranging across all market-caps. Its selection criteria are more general and more likened to the traditionally passive benchmarks. The S&P 500, by comparison, imposes additional index construction criteria, most notably focusing in on 500 profitable companies within the large market-cap segment. Accordingly, S&P 500 index currently has an active share of 17% compared to its benchmark. Over the last year, that ranged between 15% and 17%.
Source: FactSet
While this may not be high, it is certainly not exclusively passive. Taking it further than a criterion such as size, various style tilts are able to attain even higher levels of active share. The S&P 500 Value Index, which imposes value measures like price-to-book and price-to-sales ratios onto the S&P 500, currently has a 38% active share compared to its benchmark. That ranged between 34% and 38% over the past year.
Source: FactSet
Moving beyond both size and style, other relatively narrower factors can produce some of the highest active share levels. As an example, take high dividend yield strategies. An index such as the S&P 500 High Dividend Index, which serves as a benchmark for income seeking equity investors, is able to unlock near total active share characteristics. Currently, the index produces a 91% active share compared to its benchmark. That ranged between 87% to 91% over the past year. Moreover, other indexed factors are also able to unlock similar levels of active share compared to their benchmarks.
Source: FactSet
In the fixed income side of things, we can see potentially similar outcomes when looking at the more tailored index-based strategies. With the renewed volatility stemming from the fallout of Silicon Valley Bank and the regional banking crisis, fixed income investors are quickly re-evaluating their portfolios. Namely, reconsidering the importance of duration management, irrespective of being a regional bank or a fixed income investor. And just as with equity ETFs, the more narrowly focused, index-based strategies have the potential to be an effective portfolio solution that fixed income investors seek. A targeted selection criteria structured around factors such as low duration, has potential to unlock a meaningful degree of active share.
The ICE BofA 1–5-Year US High Yield Constrained index, for example, targets high yield bonds constrained to one and five years until maturity. Accordingly, it is able to reduce duration by 35%, while also having only around 49% overlap to the broader U.S high yield corporate debt market.
Source: ICE Data Services
In the same way, investors may look to gain exposure to specific coupon structures, such as floating rate, to help manage duration risk. The ICE BofA US Floating Rate High Yield Index, by specifically targeting floating rate, high yield debt, has just a mere 0.08% overlap to the broader U.S high yield corporate debt market while providing significantly reduced duration risk.
Source: ICE Data Services
Recognizing that more targeted index-based strategies have the potential to attain high active share results can better help investors distinguish strategies from their more exclusively passive predecessors. In particular, it can be an important measure to consider when investors are looking to reduce their broader portfolio exposures in search for specific factors to combat market volatility. And while actively managed ETFs have the potential to certainly provide these solutions, it is important to not characterize all passive in the same way.
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