This actively managed ETF has a novel approach that can cut risk and lead to higher returns

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The world of exchange traded funds is evolving. With a slew of new ETFs, you will be able to not only diversify your portfolio, but also to take advantage of active management to lower risk while keeping a handle on expenses.

Focusing on free cash flow

A company’s free cash flow is its remaining cash flow after planned capital expenditures. This is money that can be used for organic expansion, to pay dividends, repurchase shares, make acquisitions or for other corporate purposes. Free cash flow can be a better indicator of the health of a company’s business than earnings, because earnings figures can be dramatically affected by one-time events, including many types of noncash items.

“Over the long term, free cash flow is a good determinant of alpha,” Johnston said. Alpha means excess returns over that of a benchmark index.

“We look at free cash flow, strong balance sheets and a little bit of share-count reduction. As investors, we want a little bigger piece of the pie,” Johnston said.

When asked about the active component of the ETF’s portfolio management, Johnston said she was looking in the current environment for “moats,” including technological advantages.

“Recently we have been looking at currency exposure, supply-chain exposure and revenues from China,” she added.

Johnston also said she was avoiding companies that increase their borrowings to repurchase shares. “We like companies with strong organic growth, not engineered growth,” she said.

Examples of stocks held in the portfolio

Johnston named five companies held by the TrimTabs All Cap US Free-Cash-Flow ETF as examples:

An equal-weighted approach

Johnston stressed the importance of the TrimTabs All Cap US Free-Cash-Flow ETF’s equal portfolio weighting, and her opinion is backed by long-term performance of benchmark indexes.

The S&P 500 Index is weighted by market capitalization. Check out this chart, which compares the five-year performance of the SPDR S&P 500 ETF to that of the Invesco S&P 500 Equal Weight ETF :

FactSet

You can see that the equal-weighted portfolio didn’t fall as far as the cap-weighted index ETF did during the fourth quarter.

For 10 years, the cap-weighted ETF had a slightly better return:

But for 15 years, the equal-weighted approach was in the lead:

Last year, Howard Gold did a detailed comparison of returns for a variety of equal-weighted and cap-weighted ETFs in various sectors, finding that the equal-weighted approach was better for the long term, even if cap-weighted approaches might win over shorter periods.

Traditional ETFs

Investors love the convenience of traditional ETFs, including the ability to trade at any time while the stock market is open, as well as low expenses and transparency – you can see a list of the entire portfolio every day. Most ETFs track an index – either a well-established one, such as the S&P 500 or an index that is created especially for the ETF to track. This passive management style means that once the parameters are set, the ETF pretty much runs itself. That can mean very low expenses.

Transparency and performance

In April, the SEC made a ruling that is expected to lead to the creation of new ETFs that are actively managed, but “nontransparent,” meaning that unlike traditional ETFs, they will not post a full list of their holdings every day.

Some active managers understandably fear that exposing their holdings would erode their competitive advantages. Johnston doesn’t believe this is a problem, at least for TrimTabs. “In our long experience, investors looking over our shoulder most often hesitate to follow everything exactly as we do it because they might have their own opinions about a particular trade,” she said.

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