Wednesday, November 25, 2015

New-to-Market: GSLC

New-to-Market - This blog series highlights ETFs that have recently gone public and reflect those strategies currently most in demand by investors.  While ETFs are not eligible for ETFG Risk Ratings until traded for 3 months and ETFG Reward Ratings for 12 months, our goal is to highlight the most cutting-edge investment strategies that have recently embraced the ETF structure – we hope you enjoy this special series of posts.

You can’t judge a book by its cover, but you can certainly grasp the furious pace of evolution taking place in the world of smart beta strategies by studying their names.  In the last few years, we’ve gone from something now seemingly prosaic like “minimum volatility” to the likes of the "International High Dividend Volatility Weighted Index."  Maybe dealing with this increasing complexity is the reason why we wrapped our minds around Goldman Sach’s first exchange-traded-fund, the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC), the premier offering of new products using their “ActiveBeta” strategy.  Coming from Goldman, we expected a complex strategy involving almost inconceivable factors (like a price-to-name recognition ratio) but instead were confronted with a 400+ holding, 9 basis point fee and a seemingly index hugging product.  In researching the strategy, we discovered that Goldman had attempted to do something truly evolutionary in the world of smart beta strategies; create something for the investment masses to be used not as a small satellite but as a core holding.

To fully grasp GSLC and Goldman’s new strategy, you must first acknowledge that while it does have the words “Active” and “Beta” in the name, the fund is unlike any other smart beta strategy and requires you to consider the target audience.  Smart Beta products typically start with a well-defined equity index and reweight positions to capture exposure to a specific “factor” or investment style such as high momentum, valuation or low volatility.  Focusing on a specific portfolio attribute generally means having a much smaller pool of securities in the fund.  While that might be a good way to add alpha, the concentrated exposure ultimately limits usefulness in your portfolio - would you really want to put 30% or 40% of your assets in a low volatility fund?

Any investment advisor would be hesitant if they compared the annual returns of different strategies as with smart beta, timing is everything.  Consider two of Blackrock’s latest offerings, the iShares MSCI USA Value Factor Fund (VLUE) and the iShares MSCI USA Momentum Factor ETF (MTUM) where MTUM outperformed VLUE by just under 200 bps in 2014 delivering a 14.6% return to VLUE’s 12.8% and 13.7% for the S&P 500.  So far, so good but fast forward to 2015 and VLUE is down 1.8% (through November 23rd) while MTUM is up 9.5% in the same period and the S&P 500 is up 3.3%.  While that’s an impressive return for MTUM, the return was generated in no small part by a 44% allocation to consumer discretionary and technology stocks which could provide more exposure to that sector than the average portfolio might require.

Instead of back testing a strategy to deliver breathtaking alpha without concern for tracking error, Goldman’s focus is on trying to deliver a positive information ratio over an extended period of time by developing “core” holdings that provide diversification with the possibility of alpha versus a static benchmark for a reasonable cost.  While that might not be as sexy as outrageously high outperformance, it’s something that even the best active managers struggle to do.  How GS does that is through their “ActiveBeta” system.  Instead of trying to capture exposure to just one style, ActiveBeta incorporates four of the most popular smart beta strategies including value (looking at several common multiples), quality (gross profits divided by assets), low volatility and momentum.  Investors who are looking for more active alpha might consider this approach to be something akin to “crockpot” investing where you simply dump all the ingredients in at once and set it to simmer for eight hours hoping the end result is something edible, but Goldman believes that investors need to consider how a fund works within not only their portfolio but their personal investment style.  A pure factor fund requires a tremendous investment of time for research and due diligence (not to mention monitoring after you buy it) and which most investors simply aren’t willing to commit to and as our value to momentum example illustrates, could lead to very poor outcomes.

Knowing that these strategies were intended as core holdings will make the discussion about portfolio construction much easier to understand.  First, they’re passively managed and reconstituted quarterly. They begin building their benchmark by using a well-diversified index, for GSLC this is the Solactive U.S. Large Cap Index.  They then rank each component using the four factors to arrive at a “factor score” and then equally weight the scores to determine the weighting.  Seems simple so far, but those scores aren’t used directly to determine individual weightings as Goldman has a cut-off system where scores above the cutoff result in an overweight relative to the Solactive index while being below results in an underweight which as a long-only fund means the lowest possible allocation is zero.  Using a well-diversified benchmark of large-cap stocks might be enough for those investors concerned about taking on stock-specific risk or large sector overweight’s.  Goldman went the extra mile and added additional weighting criteria to each sub-index including keeping target weights for each industry within a specific percentage of the benchmark where no one industry can be more than 25% of the index and that the sum of all positions of more than 5% can’t be more than 25% of the portfolio.  In order to keep trade costs reasonable (and the management fee in-line with large-core funds), the fund’s managers employ a system of bands around individual positions rather than trading every stock to an exact model weight every quarter.

The net result of those target weights and cut-offs is a large-cap portfolio with 433 holdings that some investors will assume bears too much similarity to a static benchmark to deliver on its smart-beta claims, but compare GSLC to most advisors preferred large-cap benchmark, the S&P 500 (we’ll use SPY), and you’ll find it’s a very different story.  Perhaps the most noticeable difference between the two is that while there is a significant degree of overlap in their holdings, GSLC has a much lower average market cap than SPY at $48.3 billion to the market’s $75 billion and it’s done by slightly trimming allocations to mega-cap stocks like Alphabet and Apple and increasingly the allocation to more attractively priced mid-cap names including some that are outside of the S&P 500.  One notable example is Lear Corp (LEA) that’s up over 16% since GSLC launched in late September thanks to its strong earnings outlook which earned it a .44% allocation in the fund.  Where that money came from illustrates how the principles of momentum and volatility factor investing interact within GSLC as the fund has a notable underweight towards energy stocks at just 3.6% of the portfolio compared to SPY’s 6.9% in favor of consumer discretionary names at 18% of the allocation versus 12% for SPY.  Retail stocks have outperformed broader equities for much of the year as a rising dollar adds gives consumers more purchasing power, but given the performance that some of GSLC’s overweight’s like Goodyear Tire and Activision have already delivered in 2015, investors could understandably be nervous.

GSLC may or may not be the high alpha generator you would have expected, but it might just be a perfect fit for that smart investor looking for a solid core fund that pays off over time.

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