Index Investing vs Active Investing

Over the past 5-10 years we have seen an explosion in the use of index based passive investments. Most of these investments have been through the use of Exchange Traded Funds or ETFs.  These Index based passive investments have largely replaced actively managed mutual funds and hedge funds in the clients' portfolios that have chosen to use them.  

By and large I view this innovation in the wealth management industry as a positive thing. The simple facts are that the vast majority of actively managed funds will not beat their benchmark after fees, and that is not likely to change in the future.  So for many amateur investors, the ability to diversify their holdings at very cheap management fees COULD be a very positive thing for their long term financial plans. However, as with all investment trends, the positive aspects of the fad tend to get overblown. ETFs which are passively based are not perfect investments, and I thought it would be good to talk about some of their limitations and some of the reasons why you would not use an ETF or other passively investment so that you can have a balanced and informed opinion when selecting an ETF.

Despite their newfound popularity, passive investments are not a new thing.  The first passively invested mutual funds were created in the 1970s by Peter Bogle at Vanguard.  As such we actually have a pretty long track record of how passive investments actually perform relative to their actively invested competitors. One important thing to remember at the outset is that passive investing and ETFs are not necessarily the same thing.  

There are some ETFs which actually employ active managers to manage the assets of the ETF, whereas there are also index based passive mutual funds which are structured more like traditional mutual funds and are not ETFs.  By and large though most ETFs are in fact based on some index and are a passive investment, and for the sake of simplicity when I refer to ETFs in this article I will be referring to passively invested ETFs.

Exceptional Managers Will Still Outperform the ETFs

Warren Buffett has been one of the most vocal supporters of ETFs over the past few years. He rightly points to their low cost as the main benefit, and also the main reason why they will outperform the majority of actively based funds.  He has also been heavily critical (again, rightly so in my opinion) of the fees charged by Wall Street and the financial industry in the past.  I would 100% agree with Buffett on all of these points.  All of this would suggest that Buffett invests all of his own money into ETFs right?

Well as you might expect, Buffett continues to invest Berkshire Hathaway's capital in a very active way along with his partner Charlie Munger.  In fact he has hired two managers Ted Weschler and Todd Combs to succeed him and Munger as the next generation of Berkshire active managers to allocate capital when Buffett and Munger are gone.  In fact Buffett has been very careful to state even when praising ETFs that some exceptional managers will still outperform a passive investment. This wouldn't help us unless we can identify who these exceptional managers will be ahead of time.

Fortunately Buffett has already given us the tools to identify these managers.  In his article, The Super Investors of Graham and Doddsville (which was originally a speech given to the Columbia Business School in 1984), Buffett clearly addresses this same argument over 30 years ago, AND he also tells us where we need to look to find investors who will beat the market in the future. Clearly if a manager is going to outperform the passive index, he or she is also going to outperform a passive investment based on the index.  The tools to identify these managers are available for anyone to read.  

The reasons why they haven't been used in the past are: Most investors do not have the background knowledge and experience to identify the traits necessary in a manager to outperform. A fund manager who is going to outperform must be very concentrated in their holdings usually.  (If you're going to beat an index, you can't own a majority of the index) This concentration can lead to volatility which is unpalatable for many investors and certainly for many companies that manufacture and sell mutual funds.  

Investors have been taught not to put all of their eggs into one basket, which is true to an extent.  However, too much diversification will prevent a fund manager from outperforming. Even managers who outperform over time will have long spells where they will underperform. Most investors are not disciplined enough to stick with them through their underperformance.

Complexity

One of the main problems with ETFs is that as they've grown in popularity, they have also multiplied exponentially, to the point where there are now more ETFs that are traded than there are stocks in North America.  This means that the selection of a proper ETF is now often just as complex as selecting an individual stock.  

Some examples of the more specialized ETFs include ones that only invest only in whisky makers (WSKY), or one that only invests in companies that cater to millennials (MILN), or how about one that invests in companies which are trying to fight the global obesity epidemic (SLIM).  With selections like these available it is no wonder how some amateur investors have a hard time figuring out which ETFs are the right ones for them.

Tracking Error

An undisclosed cost of any passive investment is the tracking error an investment has with its underlying index.  The tracking error is a term used to describe the difference between the performance of the ETF and of its underlying index.  For various reasons including timing, liquidity, the cost of trading, and availability of the securities in an index, the performance of an ETF is never going to be exactly the same as its underlying index.  Over time this tracking error becomes an undisclosed cost which drags on performance. This tracking error can be huge in periods of large volatility as the price of the ETF can disconnect from the underlying index.

An example of this would be on August 15th, 2015 when the S&P 500 opened -0.3% lower, but the SPDR S&P 500 ETF (SPY) was trading down -5.2% at the open.  That's a tracking error of -4.9%, far greater than the cost of any actively managed fund.  Under normal conditions the tracking error would be much smaller however it is still there and would vary based on which index the ETF was tracking.

The Ability to Invest like an Amateur

Now let's address the elephant in the room.  The main reason for the popularity of ETFs has been their lower costs and some amateur investors see this a way to replace their high priced advisors.  Investors have good cause to try and reduce their fees as many investors have been paying very high fees with only very marginal value being provided by their advisors.

ETFs make it very easy for investors to get wide exposure to a particular sector, industry, country, asset class, or even the whole world (ACWI).  This ease can be a fantastic thing, as investors can quickly get exposure to whatever market they choose.  However because it's so easy, it can cause problems for amateur investors. Investors now have the ability to buy very complex financial instruments and because of this they are being grossly misused.  Just because someone has the ability to buy the inverse of the volatility index (XIV) doesn't mean that they should (XIV was once brought to me by a retail investor as something he wanted to invest in.  It is a great example of an investment which is not suitable for amateurs).

What's even more alarming is that ETFs are being traded a lot more rapidly than other traditional investments have been traded before.  One way of measuring this is to measure how long it takes for a security to turnover its float.  The top 10 S&P 500 constituents turn over their floats in an average of 187 days. The quickest turnover is Apple at 40 days and the slowest is Berkshire Hathaway at 300 days.  The turnover of some major ETFs is as low as 1.7 days for the iShares Russell 2000 ETF and 4.3 days for the SPDR S&P 500 ETF Trust.

This is a very rapid turnover and suggests that there are a lot of people day trading ETFs which is probably a poor investment strategy in the long term – especially when you factor in transaction costs on trading.  In fact when you factor in those higher transaction costs many investors are actually paying more for their ETF portfolios than they were for their old active management investments.

One of the things that isn't factored into investing in ETFs is investor psychology and the effect that volatility has on an investor's mindset.  For example, if you had invested passively in the S&P 500 through the SPDR S&P 500 ETF Trust (SPY) over the past 15 years you would have achieved a fantastic return of 9.78% annually.  This is a phenomenal return which would have far exceeded any projected return in a financial plan or retirement projection that we've prepared. However you would have also had to endure a period from October, 2007 to March 2009 where your entire portfolio would have gone down by about 57%.  In other words you would have lost over half your money.  Very few investors (professional or amateur) would have had the fortitude to stick with their same investment when faced with losses like that.

For amateur investors I would say it's next to impossible to think they would have continued to hold on to their SPY after watching it fall by over 50%.  Far more likely that they would have sold AFTER incurring huge losses and would have missed out on the subsequent recovery and bull market.  In fact statistics show that is precisely what amateur investors did as their returns substantially underperform the SPY even for those amateurs that invested in SPY.  

This is where an active manager can really add a ton of value to the client if they reduce the downside risk to the portfolio.  Traditionally active management has outperformed in down markets over passive management and this means that an actively managed investment will lose less money than a passive one in times of market turmoil and an investor will therefore be less likely to jump ship when losses occur.

Based on all of these factors the decision to switch to ETFs is a little closer than it originally looked.  ETFs will still do the job for most investors and in many cases they may even be the best option available.  However for investors who have a little bit more knowledge and experience, and know what to look for, an active manager can still add value to a portfolio.

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.