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What to Look for When Choosing an Active ETF

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This article was originally published on ETFTrends.com.

Actively managed ETF strategies may offer benefits that some investors might not be aware of when thinking about active management.

On the recent webcast (available On Demand for CE Credit), Advantages and Opportunities of Active Management in an ETF Wrapper, Dodd Kittsley, Director of ETF Strategy at Davis Advisors, argued that actively managed ETFs may be getting a poor rep as many would associated this investment category with the underperformance in the broader active fund industry. Many investors have given up on active investments as $1 trillion flowed into U.S. domestic equity passive funds over the decade period ended 2017, compared to the $1.1 trillion in outflows U.S. domestic equity active funds experienced over the same period.

However, investors may be painting the active fund space with broad strokes, ignoring potential opportunities. Kittsley pointed out that active and passive performances have been cyclical. Specifically, passive investments tend to outperform in very strong market conditions while active tends to outperform in a variety of environments. As we head toward the end of the business cycle and the bull market rally starts to slow, the good times for passive strategies may be harder to come by, potentially allowing actively managed strategies to shine.

As investors look into actively managed strategies, it is important to first look under the hood before committing. Specifically, Kittsley advised investors to consider attributes of a successful active manager, such as low fees, differentiating from an index, low turnover, long-term orientation, proper incentives, strong alignment of interest with clients, experienced management team and a proven track record.

Rusty Vanneman, Chief Investment Officer for CLS Investments, also highlighted the importance of screening active managers to separate the wheat from the chaff. Specifically, Vanneman emphasized low costs; looked to portfolio managers who "eat their own cooking" or show conviction in their own process and are aligned with investors; considered stewardship or the corporate culture of the management team; and low portfolio turnover.

Screening for these attributes of a successful active manager can help investors hone in on better investment opportunities. According to Morningstar data looking into U.S. domestic large-cap equity funds filtered for the quartile with the lowest net expense ratio and highest manager ownership, Kittsley found that 89% of these select active funds outperformed the S&P 500 over the past decade, compared to just 24% of the broad unfiltered U.S. large-cap category.

To produce their outperformance, successful fund managers are able to take advantage of market inefficiencies. For example, managers would take into account time arbitrage; intangibles like management, capital allocation, competitive moat; sector inefficiencies; accounting arbitrage; geographic inefficiencies such as understanding the foreign markets; and business bias versus profession.

What you are left with is an active fund strategy that can be differentiated from an index. For instance, the Davis Select Financial ETF (DFNL) may follow the same category as the S&P Financial Sector, but DFNL takes on more overweight exposure to mid-sized opportunities and reduces its tilt toward large Wall Street names. The Davis Select International ETF (DINT) provides similar exposure to the MSCI All Country World Index ex US, but DINT takes on a more focused approach to a number of select international opportunities with strong earnings-per-share growth potential and cheap valuations or low price-to-earnings.

Financial advisors who are interested in learning more about Davis Advisors’ investment strategies can watch the webcast here on demand.