Talking Heads – Offering the best of active and passive investing in ETFs

Podcast Charles Cresteil on alpha enhanced ETFs

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing active ETFs. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Charles Cresteil, Investment Specialist. Welcome Charles, and thanks for joining me.

Charles Cresteil: Hi, Daniel. Thanks for having me.

DM: There’s been many developments in the ETF space over the years, increasing inflows going to ETFs, and a lot of investors assume that this is always at the expense of active mutual funds. But one of the more interesting developments that we’ve seen is the development of active ETFs: an actively managed strategy, but with the advantages that you look for from exchange-traded funds. Could you explain what active ETFs are?

CC: Active ETFs are a new generation of investment solutions. Essentially, what they do is try to combine the features that have made ETFs popular with the expertise of active management. The goal is to offer investors the best of both worlds, the ease of trading and the transparency that comes with ETFs and the potential for higher return that you get from active investment strategies.

In recent years, what we’ve seen is the real surge in demand for active ETFs, especially in the US, But now we’re seeing that trend pick up in Europe too. In fact, flows into active ETF have increased by more than 55% annually over the past year and a half. In that context, we decided to launch a range of six new active ETFs: three focused on equities and three on corporate bond markets. They are enhanced, meaning that the level of tracking error that they target sits between active and passive solutions.

For listeners who may be unfamiliar with the term, tracking error here refers to the measure that evaluates the deviation between the returns of a portfolio and of its benchmark. So, a lower tracking error means that portfolio performance is more closely aligned with that of the benchmark.
Alpha refers to the idea of outperforming the benchmark index. Alpha is essentially what you get on top of benchmark returns.

To sum up, active ETFs trade on a stock exchange just like any regular ETF, but they’re designed to go one step further by generating returns that exceed their benchmark even after accounting for fees.

DM: So, there is a variety of investment approaches that that have been used for active ETFs. Could you talk about the investment approach that you’re using for these active ETFs?

CC: Our alpha ETFS follow a multi-factor approach. They focus purely on security selection, using well-established investment factors such as value, quality, low risk and momentum to pick the right stocks or bonds. These factors capture key company traits like how inexpensive a stock is relative to its peers, so that’s value; how stable and less volatile it is, that’s risk; how profitable and well managed the company is, this is the quality factor; and how strongly it has performed relative to others in terms of market returns, earnings or sentiment, and this is the momentum factor.

Choosing how we build the portfolio is just as critical. One of the basic principles in finance is that you only want to take on risk if you’re getting properly rewarded for it. So, in developing our multi-factor strategy, we put a strong emphasis on controlling unwanted risk. This approach of neutralising risk that doesn’t contribute to alpha is what makes multi-factor efficient in terms of risk adjusted return.

It’s about building a portfolio that stays close to the benchmark that gives you an edge by leaning towards stocks or bonds that we expect to outperform. What also makes this range stand out is that it applies the same investment philosophy across both equity and corporate bonds.

DM: You’ve talked about the construction, the management of the active ETFs. Now let’s look at it from the client’s perspective. How should they go about selecting active ETFs and using them in their portfolios?

CC: Think of active ETFs as a building block. They can complement both passive investments and any traditional actively managed solution that you already have in portfolio. They’re designed to help diversify your portfolio and give you a chance at improving overall returns. I should mention here that when we say diversification, we are talking about alpha diversification.

Combining strategies with more fundamental ones can help smooth out returns over time. From an investor perspective, when selecting ETFs, analysing the quality of the ETF platform is key. Things like liquidity, transparency and the quality of the market making and the technology framework. It is crucial to also look at an asset manager that is recognised for its investment capabilities with a track record of generating performance with a controlled risk.

DM: If I could summarise some of the points that you shared with us. Active ETFs are the best of both worlds, offering the ease of trading and transparency that you look for in an ETF, alongside the potential for higher returns from active management. You noted that active ETFs have seen significant inflows over the last couple of years and highlighted the quantitative approach to managing the active ETFs. Well, Charles, thank you very much for joining me.

CC: Thank you, Daniel.

DM : That’s it for this week’s episode of Talking Heads. If you would like more information about active ETFs, please reach out to your BNP Paribas Asset Management contact or check out Viewpoint, our website for investment insights at viewpoint.bnpparibas-am.com. We recommend subscribing to Talking Heads on your favourite podcast channel such as YouTube or Spotify. You receive your podcast episodes every week. If you like Talking Heads, leave us a positive review and a nice rating. You’ve been listening to the BNP Paribas Asset Management Talking Heads podcast with me, Daniel Morris, and Charles Cresteil, Investment Specialist. Please do join me next week. Until then, take care.