Combine active and passive ETFs for strategic portfolios

Generate alpha while enhancing diversification

While many investors continue to debate the merits of active versus passive ETFs, opting for an “either-or” approach to portfolio construction may ultimately prove misguided. The truth is that blending active and passive strategies in a complementary fashion can potentially generate alpha, enhance diversification, and help minimize volatility.

We believe that both active and passive index ETFs provide significant value to investors – even more so when combined strategically. While passive index strategies can deliver market exposure cheaply and efficiently, the investment flexibility of active ETFs can potentially deliver outperformance and provide critical downside protection – especially in volatile markets like we’ve seen in 2020.

Actively generating alpha

Since the emergence of the Covid-19 pandemic, global markets have experienced unprecedented volatility in virtually all sectors and regions. While many have hoped for a V-shaped economic recovery, it seems that market volatility is here to stay for quite some time. While wild price swings can be unnerving for some investors, active managers can take advantage of market dislocations, selling overvalued equities to take profit and/or acquiring undervalued companies with the potential for significant capital appreciation during a market recovery.

Because active managers don’t have to match an index’s holdings, they can position their portfolios more defensively during market pullbacks, providing a level of downside protection that can’t be matched by passive ETFs.

It’s also important to note that active managers who are focused on clean balance sheets, free cash flow, and minimal exposure to cyclical sectors (like consumer discretionary and financial services) tend to shine in volatile markets and over the long term.

Additionally, active ETFs featuring high active share (i.e., with little overlap in the benchmark’s holdings), provide a greater potential for alpha generation. After all, it’s hard to beat the index if you look exactly like it.

Diversification the active and passive way

Passive index ETFs that track major indexes, like the S&P 500 Index or the MSCI EAFE Index, are usually based on a company’s market-cap – the larger the company is, the greater its weight in the index. While index ETFs provide a level of diversification and often hold hundreds of companies, it’s worth noting that the top holdings can often skew an index’s performance. For example, at the time this article was written, the top 10 holdings in the S&P/TSX Composite Index accounted for 38% of the index, while the top three sectors (Financials, Materials and Energy) accounted for over half of the index’s weight. Meanwhile, the top four holdings in the S&P 500 accounted for nearly 20% of the index’s performance.

For enhanced diversification, investors should consider complementing their passive ETF holdings with active ETFs featuring concentrated portfolios, high active share, and strong diversification across sectors, regions, and market-cap.

The added diversification can help minimize risk – especially during periods of prolonged volatility. Active managers have the freedom to raise cash levels during these periods and avoid declining stocks or sectors. In fact, over the past 35 years, the percentage of active managers who historically outperform their benchmarks has spiked during market declines.¹

For example, Dynamic Active International Dividend ETF (TSX: DXW) provides heavy geographic diversification across 17 countries to complement the holdings in the MSCI EAFE Index, which skews toward Japan and the U.K., accounting for nearly 40% of index’s holdings.

Managed by an experienced portfolio management team with a focus on balancing risk and return potential, DXW is focused exclusively on dividend-paying companies and is not restricted to sector, country, or market capitalization. The ETF’s strong international focus also provides for investors who may be over-allocated to U.S. equities.

While U.S. markets have certainly outperformed over the last decade, Dynamic Portfolio Manager Kevin Kaminski has one surprising statistic for equity investors. “Every single year some three-quarters of the top-performing stocks are non-U.S. stocks,” he says. “If you’re not invested internationally, you’re missing a world of opportunity.”

1. “Active Versus Passive Investment Management: Analysis Update,” Arnerich Massena & Associates, Inc., August 2010

Alan Green is Director, ETF Capital Markets, at Dynamic Funds. This article previously appeared in the Fall 2020 issue of Your Guide to ETF Investing, published by BrightsRoberts Inc. Used with permission.

Important information

© 2021 by Dynamic Funds. All rights reserved. Commissions, management fees and expenses all may be associated with investments in Dynamic Active ETFs. Please read the prospectus before investing. Investments in ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. Certain Dynamic Active ETFs are managed by BlackRock Asset Management Canada Limited and invest in selected mutual funds managed by 1832 Asset Management L.P. Dynamic Funds® is a division of 1832 Asset Management L.P. ®Registered trademark of its owner, used under license. Views expressed regarding a particular investment, economy, industry, or market sector should not be considered an indication of trading intent of any of the mutual funds managed by 1832 Asset Management LP. These views are not to be relied upon as investment advice nor should they be considered a recommendation to buy or sell. These views are subject to change at any time based upon markets and other conditions, and we disclaim any responsibility to update such views. To the extent this document contains information or data obtained from third party sources, it is believed to be accurate and reliable as of the date of publication, but 1832 Asset Management L.P. does not guarantee its accuracy or reliability. Nothing in this document is or should be relied upon as a promise or representation as to the future. For enhanced diversification and alpha generation, consider a complementary approach to building your equity portfolio. MKTGH0120C-1068362

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