XYLG - TUG: An Active ETF That Aims To Be A Hedged Version Of QQQ

2023-12-27 02:27:03 ET

Summary

• STF Management's Tactical Growth ETF is an actively managed ETF that aims to stay invested in the market while providing downside protection.
• TUG has shown strong returns in 2023, but its performance is heavily influenced by market conditions and the effectiveness of its proprietary algorithm.
• The fund's strategy involves assessing trend following, volatility, and momentum metrics to determine its equity exposure, with a focus on the Nasdaq-100 index.

We are skeptical of many active ETFs, but think this one, STF Management's Tactical Growth ETF ( TUG ) is different. Different enough to put a Buy rating on it. Simply put, the investment market climate heading into 2024 requires flexibility, perhaps more than ever. And, while the risk is always that tactical ETFs that use asset allocation switching strategies like this one can be victims of human error. But we assess that in the case of TUG, the approach has enough of a risk-management discipline to reduce the "blowup" chances we see in other tactical allocation strategies. So, we see TUG as being a different animal.

TUG: Key Data Points

TUG is in its third year, having debuted in May of 2022, in the throes of one of the worst years for the stock and bond markets on record. It has gathered $169 million in assets, which tells us that investors have not hyper-focused on the expense ratio, which is 0.65%. To us, that's a fair price to pay for a fund that has alpha potential in any market environment, which is the case with flexible ETFs like this one.

TUG's holdings at any one time depend on how much it is allocated to equities. And when it allocates to equities, it owns the Nasdaq 100. In that sense, it can be considered an alternative, hedge-able version of the wildly popular Invesco QQQ Trust ETF ( QQQ ). QQQ is fully invested at all times. TUG is not. So there will be times when TUG owns minimal or no equity exposure. But when it does, it is essentially allocated to a QQQ-like portfolio to the extent it owns stocks. The rest of the portfolio is in bonds or T-bills.

In other words, the decision system here is about how much to allocate to equities at any time. TUG was created with an alluring premise in mind: staying invested in the market is necessary for capital appreciation, but it's human nature to want to pull your money out when losses happen or uncertainty looms on the horizon.

Market timing systems are everywhere, from hedge funds to TikTok and in between. The tendency of these "black box" systems is to work well in back-testing mode, then do a good job...until they don't. Then, their returns often stagnate, or worse, the "algorithm" or other trading mechanism backfires because the market stops working the way it used to.

Our thesis is based in part on the fact that this ETF, which debuted in mid-2022, is actively managed, but in an ETF wrapper.

Tactical allocation ETFs can take away some of the fear of losing money and missing out on gains, making them a potential core holding in a portfolio. But one has to have an extremely high commitment to, and understanding of, the process, and proprietary models such as this one doesn't typically allow us to see exactly how the gears turn inside the proverbial watch. We just get to see what time it is (i.e. the results of the process).

We see good signs here so far, though we'll feel stronger about our Buy rating once we see how it performs in a choppier or downward-trending market. So far, so good, as we see it.

TUG In 2023: Strong Returns, But As Expected

TUG is up 34% year-to-date through Tuesday's close, so that's some nice "eye candy" for investors to see. But it should be doing well, given the combination of a strong Nasdaq 100 performance and the fact that 2023 has been far less choppy than the previous year. That has allowed the algorithm to stay bullish and allocated heavily to equities.

But as with any tactical strategy, particularly one based on a proprietary algorithm that rotates between the Nasdaq 100, T-bills, and US Treasury bonds, the elephant in the room is always the same: will the algorithm be rewarded by markets the same way as it has been in the past? Events occur over time that change how certain relationships between securities behave.

And will the active manager running the fund be willing and able to adjust the automated process before such an event occurs? We need only to look at how bonds are used to complement stock beautifully. Then, after 40 years of generally bailing each other out, 2022 happened, and both fell sharply.

TUG Of War Between Upside And Risk Management

Regardless of its limited tenure, it is important to understand how the fund aims to achieve its core functionality. TUG's process involves assessing a combination of trend following, volatility, and momentum metrics, resulting in a decision about what the fund's equity exposure will be. That exposure is always to the NASDAQ-100 index, with the stocks bought directly.

US Treasury bond and T-bill exposure is the result of the manager's assessment of how correlated they will be to the equity portion of the ETF. So, TUG can potentially reduce risk via lower equity exposure, rather than by using a shorting strategy or put options. The process is entirely systematic but designed and overseen by humans.

TUG: Simple And Sophisticated, But Opaque And Hyperactive, Too

Because this is more of a rules-based or quantitative fund, it's hard to predict how it will act in every scenario, since we don't know the inner workings of all of the conditions and factor weightings involved. Instead, we can attempt to estimate its potential by looking at how quickly the fund changes direction to avoid further losses or to rejoin the market when an uptrend develops. We can see the total return of the fund below, as well as how the QQQ performed over the same period. The chart shown earlier shows that TUG exhibits a strong positive correlation to QQQ, but its risk-management discipline limits its upside in roaring bull markets for the Nasdaq.

The ETF's annual trading turnover rate of more than 400% doesn't bother us at all. That simply means that it flipped from a high equity position to a low or no equity position several times in a 12-month period. That's tactical management, with a strong "in or out" timing mechanism in action. The chart below shows a small sample size example of how TUG apparently tapped the brakes during the autumn of 2022, which made a big positive impact on short-term returns in that more than 15% slide in QQQ.

TUG rarely fully participates in rallies but does offer some degree of downside protection. The time segment above is the only period in which TUG has outperformed the QQQ since inception. What excites us most about the possible benefits of this active strategy is if it were able to navigate a steep, bubble-busting breakdown in QQQ, a la 2000-2003. The potential is there.

TUG Versus Its True Peers

This ETF is one of a flood of funds in recent years that are trying to get most of the stock market's upside, but with less downside risk. They come in many varieties, most often using covered call options. So some analysts will instinctively compare TUG to other active/tactical strategies. We look at it differently. We should compare TUG to other methods of trying to invest in QQQ, but without being 100% invested as a mandate.

What we see in the chart below is that when compared to ETFs that own a QQQ-like stock portfolio, and then use at the money covered calls against it in whole ( XYLD ) or half (XLYG), TUG has outperformed since its inception.

However, we also see that there will be times when the TUG methodology will lag these types of strategies as well as QQQ, either because of low equity exposure in a rising market or because it uses bond allocation to hedge and rates go up, reducing bond prices. But we also see how quickly it can recover like QQQ itself has done repeatedly over the years.

Current Investment Opinion

In a Nasdaq-led market environment like 2023 has been, TUG will more than likely underperform as the algorithm builds conviction toward being maximally allocated to equity. Because of this, longer time periods are needed to really see how their specific set of rules holds up over an entire market cycle, or at least a variety of periods with up, down, and sideways price action. Until we have more scope and further conclusive data on the fund's ability to preserve capital, it's difficult for us to buy into this ETF, even if the premise is quite interesting.

We are willing to issue a Buy rating on it here, more because we think the structure and process will endure, rather than because we think it is going to fly higher in the near term. This recommendation is based more on process than short-term performance, since TUG aims to be a different type of core portfolio position, one with the risk management focus we look for.

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