Exchange-traded funds have changed the nature of the debate between active management and passive investing.
Passive investing once involved holding a broad-market index fund and comparing performance against an active manager who used the same benchmark. What essentially differentiated an actively managed fund was that it was exposed to individual stock risk, according to a leading indexer. All the other issues, such as style or strategy or stock weighting are now addressed by ETFs and index funds.
As a result, by indexing, “you’re likely to be close to the market performance,” explained David Blitzer, managing director of index management and production at Standard and Poor’s, speaking an the IMN Canada Cup of Investment Management last week. “That doesn’t mean you’re making money.”
Still, he prefers to call passive investing “intelligent” investing. Active investing, by contrast, is the market return, plus or minus manager skill. “The volatility or variability of the active manager is most likely if not almost certain to be higher than the variability of the index manager.”
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ETF explosion
But the debate has moved to another plane, thanks to ETFs. What ETFs have done, Blitzer says, “is to open a huge range of options available for all investors, including the ones who use indices, whether it’s different weightings, different sectors of the market, and taken us all way beyond the equity market. We can all buy as an equity, or allegedly as an equity, oil, gold, a huge range of fixed income securities … and a huge range of hedge funds or hedge fund-like securities.”
While diversifying the stock-specific risk in active management, ETFs have also opened the way to active management of beta exposure.
That’s a trend investment advisor Rick Ferri, president of Portfolio Solutions, sees in the U.S. In the old debate, only 30% of active managers beat the benchmark—an index fund—he notes. Underperformers lagged by 1.7% on average. Outperformers, however, beat their benchmarks by only 1%.
Given that two-thirds of active managers underperform, “a fair payout for the one-third of the managers that outperformed should be double what the underperformance is. So it should be about 3%,” he says. “So even when you win, you lose because the payout isn’t high enough. So you’re taking risk and you’re not getting paid for taking that risk.”
Each additional fund in a portfolio reduce the probability of beating indexed products, he adds. With five funds, the probability falls to 18% from 30%. What’s more, the probability the portfolio of beating a benchmark diminishes to just 1% per year over a 25-year holding period.
“It’s possible to beat the market,” he explains. “It’s just not probable.”
Against those results, Yves Rebetez, vice-president of structured products and ETFs in the portfolio advisory group at RBC Dominion Securities, sets the experience of most investors in the recent bear market. If markets were efficient, how did they get so low?
“I think perhaps the answer is a mix of active and passive, trying to find the one-third of managers—realizing that you may not stay with them for 25 years—and lastly using ETFs and then deciding what exposure to get,” says Rebetez. ETFs offer investors the choice between what risks they want to take on and what risks they don’t. But, he admits there’s a challenge in understanding what’s in a particular ETF.