For this post, I am pausing my usual discussion of the nuances of exchange-traded funds (ETF) capital markets to celebrate a milestone. Franklin Templeton’s first active equity ETF—Franklin US Low Volatility ETF (ticker, FLLV)—just celebrated its five-year anniversary. I recently interviewed FLLV’s lead portfolio manager, Todd Brighton, and we discussed the evolution of active ETFs in the marketplace over the last five years and how they can address critical investor outcomes, such as managing equity market volatility. Here is a summary of that conversation.
Looking back five years, it’s really amazing to see how much the ETF landscape has changed. In 2016, ETFs were still synonymous with “passive” or “index-tracking” investing. Active ETFs were only 2% of total US ETF flows for the year. Fast forward to the end of September of 2021, and they’ve now accounted for 10% of total US ETF flows with assets now totaling more than $275 billion of assets under management (AUM). This growth is astonishing—active ETFs have a five-year compound annual growth rate (“CAGR”) of 46% while all ETFs (including active) have a five-year CAGR of just 16%.1 One could expect this elevated growth to continue, especially with the passing of the ETF Rule in which conveyed that there are no operational differences between active and passive ETFs.2
Todd emphasized how important it is to consider volatility over multiple market cycles. Since launching FLLV in 2016, there have been two periods of notably elevated market volatility. The first was in the fourth quarter of 2018 as the US-China trade war really started to escalate. The second began in March of 2020 as the world grappled with the COVID-19 pandemic. But over the five-year period, despite those blips, equity markets have generally appreciated. So, it is important for us to be able to participate in the upside as well as limit those drawdowns.
Balancing Fundamental Views and Volatility Screens
FLLV’s investment process relies on deep fundamental analysis as well as a quantitative screen to identify companies that have demonstrated the lowest level of volatility in each sector. It starts with a broad investment universe derived from holdings of several Franklin Templeton mutual funds. From there, that universe of companies is run through a multi-period, quantitative screen, which looks at realized volatility over many periods in the past. That results in a selection of stocks which are further reviewed with a fundamental lens to understand whether there is something in their business model, industry dynamics or end markets that created that lower volatility.
The Active Difference
As discussed above, FLLV takes an active approach and combines historical volatility profiles along with our fundamental views of companies. Passively managed peers use approaches that rely solely on a historical volatility screen or try to build the least volatile portfolio possible. That approach can also lead to sector biases and limit upside potential in periods where the market is performing a little more strongly. FLLV, on the other hand, aims to tries to strike that balance between managing risk while also capturing capital appreciation.
Headed into the next five years, volatility management will likely continue to be an important consideration for investors, and I for one am excited to have a horse in the race that I believe will showcase active management’s value.
What Are the Risks?
All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. There can be no guarantee that the fund’s volatility strategy will be successful, and achieving the fund’s volatility strategy does not mean the fund wiII achieve a positive or competitive return. The volatility strategy can also be expected to limit the fund’s participation in market price appreciation when compared to similar funds that do not attempt this strategy. Smaller- and midsize-company stocks have historically experienced more price volatility than larger-company stocks, especially over the short term. These and other risks are discussed in the fund’s prospectus. Active management does not ensure gains or protect against market declines. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
For more information on any of our funds, contact your financial advisor or download a free prospectus. Investors should carefully consider a fund’s investment goals, risks, sales charges and expenses before investing. The prospectus contains this and other information. Please read the prospectus carefully before investing or sending money.
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1.Source: Morningstar. Year-to-date figures as of 9/30/2021.
2.The “ETF Rule” is a rule adopted by the US Securities and Exchange Commission (SEC) that allows ETFs that meet certain conditions to go to market without the delay of obtaining an exemptive order. Passed in 2019, the rule also makes custom creation/redemption baskets available for all ETFs.