Passive Investing and the use of Exchange Traded Funds (ETFs)
An ETF is a pooled investment vehicle (generally replicating an index) with shares that trade throughout the day on the stock exchange. Many refer to ETFs as ‘passive’ investing as they essentially track an index vs. active investing where stocks are selected based on their individual merit. Active fund managers discriminate between listed companies based on their own analysis, ETFs do not.
ETFs have impacted how listed companies are now valued on share markets globally and how capital is being invested. The bulk of ETFs don’t really take into account an individual company’s valuation, profitability, management performance or financial stature.
Many argue that ETFs provide a similar exposure to that of active funds and those in favour of ETFs highlight the performance of ETFs compared to that of many mainstream managed funds. While in certain cases ETFs have outperformed some managed funds in recent years it is worth considering the following:
- The global equities industry has an array of managed fund organisations who make it their life’s-work to beat their given benchmark (generally an index) through detailed analysis, to discover mispriced opportunities in the share market every day; stock picking against the fund managers investment benchmark.
- The sheer volume of monies directed to passive index funds (ETFs) has in many instances distorted the valuations of companies listed on the ASX and other global bourses and has intensified momentum in markets.
- Active managed funds for long-term, patient and capital preservation-aware investors, should remain a focus. As part of our due-diligence process in evaluating a fund manager, we consider the tenure of the investment team and long-term performance (capturing cycles). Being able to actively manage a portfolio in down markets is an incredibly strong attribute for active managers.
- There is the assumption that ETFs are always liquid and trade at their underlying net asset value (NAV), which is true when the market is trading efficiently. However, if there is any dislocation, for example in a rapidly falling market, this can result in some ETFs trading at a large discount to their underlying NAV.
There is now an abundance of ETF options to suit all sorts of investor whims. This only adds to the appeal of having a punt on a certain theme, sector or industry via an ETF.
Why this becomes important for the deployment of capital can be explained in the following manner:
- More volatile markets tend to play into the hands of active managers as they can appropriately position the portfolio rather than hug an index.
- An active fund manager can identify expensive and cheap investments to manage the portfolio exposure and performance.
- An active fund manager can position the portfolio for loss minimisation, even if for relatively short periods of time.
- In a falling market, you are losing money. Outside of cashing out, you want to minimise this capital destruction as best you can.
Passive options tend to perform well in a low-volatility environment.
We agree that the average active fund manager underperforms the index over time, but who wants to be invested in the average? We believe by careful due-diligence and a focus on what part of the cycle we are entering, investment advisors can identify those active fund managers that will outperform an index. We believe this is particularly the case during a sharp market correction.
Index funds can play a role in portfolios as a low-cost alternative, but we need to keep a watchful eye on the valuations and distortions of the index. It is important to understanding the structure of ETFs and acknowledge that the efficient pricing of these instruments is reliant on a third party to make the markets and at times there could be a mismatch in liquidity, and thus pricing of an ETF.