Active exchange-traded funds (ETFs) have seen exponential growth in recent years as investor interest spread from the US to Europe, culminating in the launch of more than 2,000 active ETFs worldwide since their inception in 2008. In Europe, one category stands out in terms of flows and assets under management: enhanced strategies. Daniel Dornel and Charles Cresteil explain.
Active ETFs launched in Europe this year represent just under 40% of the total amid strong interest from investors. In terms of flows, we have seen an acceleration: this year flows into active ETFs total almost €24 billion. Since the beginning of 2024, the active ETF market has grown by over 60% (compound annual growth rate), while passive ETFs have grown by only 18% over the same period.
Investors favour enhanced strategies
The main objective of enhanced ETF strategies is to provide investors with well-diversified core market exposure while aiming for outperformance within a small tracking-error budget.
Enhanced products are active ETF strategies that meet these criteria:
- They aim to be representative of a standard market such as the US large-cap equity market or the euro-denominated corporate bond market
- The tracking error of the strategy against a standard market benchmark (e.g., the US S&P 500 equity index) is 1-2% for equity products and 0.5-1% for fixed income
- Portfolios are well diversified and have sector, country and risk parameters comparable to those of their benchmarks.
Enhanced strategies have seen large inflows over the past five years: €27 billion since the beginning of 2020.
One common perception is that enhanced strategies are a watered-down version of more active products. In reality, they are much more than this. Our simulations have shown that the information ratio of these strategies (measuring excess return over tracking error) exceeds that of their more active equivalent.
Multi-factor investing as a way to construct enhanced strategies
We leverage on our long-standing quantitative investment expertise to build enhanced strategies using four factors:
- Quality – favouring securities issued by the most profitable and well-managed companies
- Value – targeting financial instruments that have attractive market valuations
- Low risk – preferring assets that have been found to offer higher risk-adjusted returns on average over time
- Momentum – focusing on securities showing a strong recent performance, strong sentiment or strong earnings trends.
These factors are economically intuitive, supported by high-quality historical data. We can construct equity and credit portfolios using the same four factor styles. However, each style reflects the distinct characteristics of equities and bonds. For example, the impact of transaction costs on performance is significantly higher in corporate bond markets than in equities, making it essential to incorporate these costs directly into the factor selection process.
Securities are scored on these factors. The investment portfolio is then built using a systematic approach that aims to overweight securities with the highest multi-factor score, while ensuring that portfolio positions are such that the alpha enhanced portfolio is representative of the market, and its tracking error does not exceed the bandwidth mentioned earlier.
Attractive diversification
One notable feature of our alpha enhanced approach is the diversification in terms of alpha sources across the four investment style factors.
ETF portfolios constructed using our multi-factor approach are designed to generate alpha by leveraging exposure to the four factors. Exhibit 3 illustrates the average expected contribution to alpha across different groups of securities:
- Top-scored stocks: Securities with the highest factor scores; these typically have the largest active portfolio weights and show the greatest average expectations for alpha.
- Portfolio holdings: As intended, a well-diversified portfolio reflects exposure to all four factors, with positive expected contributions to alpha from each factor.
- The full benchmark: This typically lacks any deliberate factor tilt and a result, it has negligible factor exposure and does not provide any factor-driven alpha.
For example, for European equities, performance simulations have shown that our alpha enhanced portfolio has outperformed the MSCI Europe index since the start of 2019. Its average excess return (alpha) was 2.15% a year with an ex-post tracking-error of just 1.6% for a solid information ratio of 1.33.
As for portfolio composition, this strategy invests in some 220 stocks out of the 402 in the MSCI Europe. The sector breakdown shows similar levels of diversification compared to the index.
We believe our approach can help investors maximise their core allocations to equities and credit using a systematic and diversified factor-based process. It can offer compelling active risk relative to the benchmark with a limited tracking error, thereby improving the portfolio’s information ratio.
