Opportunities for Active Managers

The Rise of ETFs: What You Need to Know

Part Two: Opportunities for Active Managers

Part One of this series on the rise of ETFs outlined the limitations of actively managed funds, namely, the difficulty they have in delivering returns that justify the fees they charge. While this has encouraged more and more investors to turn to passive strategies, there are circumstances where investors may be better served by an active approach. There are also growing concerns around the speed and magnitude with which index-based investments like ETFs have grown, and the possible impact on the markets they track.

Which Markets Suit ETF Investing?

There are certain financial markets where ETFs might be more appropriate than others. In efficient markets that are actively traded and information is freely available such as the US equity market, ETFs have thrived as there is less scope for mispricing and therefore fewer opportunities for active managers to find undervalued investments and make above-average returns. Representative of this, three of the world’s top-ten largest ETFs track the S&P 500 and have more than USD 300 Billion in assets under management combined. However, there are other investment sectors and asset classes where an ETF might be less suitable than a more expensive managed fund. In some equity markets like in China, the index has a very large weighting towards government-linked companies – some of which may be regarded as unworthy investments as shareholders may not have the same level of importance or decision-making powers that they might have elsewhere. An ETF tracking such an index, would include such companies indiscriminately whereas a fund manager has the flexibility to choose to avoid them. Possibly as a result of this, as shown in Figure 2, ETFs have failed to grow in less efficient equity markets like emerging markets in the same way they have done in the US.

Figure 2: Lack of Growth in ETF Assets Outside of the US, Source: ETFGI

In addition, an ETF may also be inappropriate for certain fixed income or bond indices. For example, an ETF tracking a bond index of all corporate debt in a certain region would, by design, be exposed to even the most indebted and highly leveraged companies whereas, again, an active manager has a mandate to choose to moderate or even eliminate exposure to the bonds of these companies. These concerns may be mitigated by choosing an alternative index, but at the very least a potential ETF investor should be cognisant of them.

Are ETFs Creating Risk?

The huge tide of investors moving out of actively managed funds and into passive funds – Morningstar suggest in the US actively managed funds had a net outflow of USD 204 Billion for 2016 whereas passive funds had a net inflow of almost USD 500 Billion – constitutes a significant shift in investor behaviour and is having unintended consequences. Some have warned that the ETF structure has the power to create new systematic risks; ETFs are designed to be highly liquid as they are available on exchanges they can be bought and sold instantly. However, this is on the assumption that they have underlying liquidity. A rule-based investment vehicle, like an ETF, invariably creates forced buyers and sellers and if the securities into which the ETF invests are not equally as liquid, then there is the potential for ETFs to trigger a market crisis. The problem is particularly acute in relatively illiquid and inefficient markets, like emerging markets, where fast turnover can cause significant problems. While ETFs are currently thought to lack, the critical mass required to cause such a crash, there is evidence to suggest that ETFs are beginning to lead markets now, rather than track them as originally intended because they allow investors to make sweeping bets on sectors or asset classes instantaneously. As an example, The Financial Times reported that in reaction to Donald Trump’s victory in the US presidential election, investors bet heavily on US financial stocks and that two ETFs covering the sector gained 46.5% and 31% respectively in just 12 days. As investors bet with ETFs with increasing conviction, the threat of triggering a market crisis rises

Are ETFs Creating Market Inefficiencies?

While mentioned above that ETFs are best suited to efficient markets where prices are likely to be accurate, there is an argument that flows into ETFs are actually breaking down the ability of financial markets to correctly price assets and efficiently allocate money. For example, the money invested into an ETF tracking the S&P 500 is channelled into each company listed on the index, regardless of the worthiness of each constituent. The trend of ETF investing means that stocks now move more in line with one another than before. Table 1 indicates the extent of this effect: the correlation between three stocks in the S&P 500 index ExxonMobil, AT & T, and Proctor & Gamble has almost doubled between 1995 and 2015.

1995 2005
AT & T0.420.71
Proctor & Gamble0.360.73

Table 1: Correlations Between Shares and the S&P 500, Source: The Financial Times

These three companies operate in very different industries, however, the price of all three is much more strongly correlated than before the rise of index tracking investments. Of course, correlation doesn’t imply causation and it may be some other factor that is driving this change (quantitative easing perhaps), however, this doesn’t detract from the fact that an investor in an index tracking instrument is much less diversified than they were historically. What is more, the indiscriminate flows of money may mask company-specific issues and as a result, companies that have poor fundamentals but are included in the S&P 500 continue to receive investment and may become overvalued. By the same token, there are potentially other companies with good fundamentals that are less prominent in ETFs and are therefore undervalued. While there is a suggestion that constant flows into ETFs will mean it is increasingly difficult to profit from buying good, undervalued companies because they will not receive sufficient capital and therefore remain cheap, there is evidence to suggest a growing valuation gap between larger stocks that are more included in ETFs and smaller stocks that are less accessible via ETFs. It is argued this even creates an increasingly abundant environment for active managers to find undervalued securities and beat the benchmarks. This would suggest that, if investors are patient enough to base their decisions of fundamental business analysis and have a sufficiently long investment horizon, then there may be, scope for an active manager to deliver returns above the benchmark. At the moment, these concerns around passive investments are mainly intuitive, and there is little data to suggest that active managers can exploit the systemic mispricing that these concerns could bring about (if indeed it exists at all). Investors should at least be aware of the potential impacts of ETF investing on market efficiency.

One less debatable criticism of ETFs revolves around the fact that ETFs weaken the already tenuous link between the underlying company and the investor. Whereas active managers have traditionally taken a vocal role in corporate governance to protect the interests of investors, in a world where all stocks were owned entirely by ETFs, the underlying companies would be essentially ownerless, with no-one to challenge the Board of Directors or the management. We are a long way away from this scenario and it is estimated that in aggregate, only around 15% of the companies that constitute the S&P 500 are owned by ETFs, however, at the same time, the three largest providers of passive investments: BlackRock, Vanguard, and State Street, are already leading shareholders in almost every large public company on the planet.

What if an Investor Requires a Return Above the Index?

By definition, it is not possible to beat the benchmark using a fund that is designed to track it. Whilst proponents of actively managed funds are quick to point out how difficult it is to an active manager to beat the index regularly; we should remember that passive funds will always fail to do so. For an investor who requires a return above that available on the index there might be little choice but to choose an actively managed fund. The problem then faced is selecting a fund that can reliably provide a return above the benchmark and as outlined in Part One, this can be rather difficult. One method investors seeking above average returns have employed is aimed at avoiding Closet Indexers – those actively managed funds that are invested so closely in line with the index that it is very difficult for them to generate positive net returns. Recently, academic studies have tried to determine how far away from the index active managers are prepared to invest. The concept of Active Share measures the extent to which actively managed fund’s holdings differ to those of the benchmark, and might be used to judge whether a fund manager is following a strategy that he or she believes will help to offer outperformance over time. There is evidence of strong negative correlation between Active Share and net tracking error, which is the difference between the return of the fund and the return on its relevant benchmark, adjusted for management fees.

Active Share QuintileTracking Error (%)

Table 2: Net Tracking Errors for All-Equity Mutual Funds 1990 – 2003, Adapted From: Cremers & Petajisto (2009)

As per Table 2, on average, funds tended to underperform the relevant benchmark by 0.43% per year, but funds with a high Active Share overperformed by 1.13% annually.  Contrastingly, closet indexers with a low Active Share underperformed by 1.42%.  This suggests investors would generally be better served by investing in ETFs than closet indexers, when taking into consideration management fees.  At the same time, their findings imply there is still room for actively managed funds to overperform their benchmarks.

What Should Investors Do?

While the rise of ETFs is founded in the well-documented difficulty that actively managed funds have had in delivering positive relative returns, there are a number of situations where a passive methodology may be inappropriate, and there is no hard and fast rule on when to follow one or the other.  For an investor, evaluating which investment strategy is best-suited to their requirements in such a complicated investing universe can be an extremely daunting task.  Part Three in this series explains how AAM assist clients by explaining the various options and offering advice on each.