Back in the 1800’s when the World was becoming more connected, as railway lines increased mobility of goods and people, and telecommunication kept us in touch with people around the World, in a way post letters couldn’t. Despite all this advancement it was not uncommon to find cities that had not moved with the times, or rather that could agree on the time. Standard time was only adopted in the mid 1800’s by railway companies that sought to timely delivers their passengers to their respective time-zone destinations; these companies became the backdrop for the adoption of Standard time by Governments across the World. Isn’t it time for asset consultants to start looking at the active management elements of passive managers. While this makes a case for allocations into Exchange Traded Fund (“ETFs”) generally, this article is intended to create a mind shift in how ETFs and their respective managers are viewed.
Passives (‘ETF managers”) are typically considered as managers who track an index without having to apply resources to make active stock picks. The manager typically has no say in what happens to the index constituents and does not do deep research in the companies represented by the index. The skill of being able to anticipate and profit from stock upside and downside, is the skill active managers bring to the fore, compared to an ETF manager who only periodically rebalance a portfolio regardless of market conditions. With this backdrop we’ll explore the dynamics of Active and ETF managers at grassroots, to ask the question are passives really active?
THE BASIS OF INVESTING
Active managers invest on the back of philosophies whether that is value orientation, long term growth, or capital protection. These philosophies are generated in-house and the portfolios set up to implement them are given suitable benchmarks to measure their performance.
ETF managers follow rules based investing, where a set of rules can be used to construct an index. The index rules are typically developed by an external party that specialises in creating indices. The ETF manager then seeks to replicate the index that has resulted from this set of rules, and the index becomes the benchmark for the ETF manager’s portfolio.
Seems fairly simple when you look at it and it leads to the question: what gives the Active manager’s basis of investing more gravitas than that of the ETF manager, the performance of both can be measured against a benchmark. The premise for investing is aimed at creating a chain of thought or a decision tree which leads to making investments that implement the managers’ philosophy which is communicated to investors.
Both Active and ETF managers are subject to Financial Services regulation. Where an Active manager has portfolios/ unit trusts which deliver on their investment objectives, ETF managers have listed portfolios which track the indices they seek to replicate. There is an extra layer of regulation on ETF managers, which comes by virtue of being listed on the stock market. This means, not only does an ETF manager have to track an index, but they also have to manage the liquidity and pricing of their listed ETFs.
Active managers can buy/hold/sell investments as they will, subject to prudential limits, however listing an ETF requires that the ETF manager tracks an acceptably constructed index. This means the investment philosophy of the ETF issuer must find a way to be indexed, otherwise it cannot be listed.
MODUS OPERANDI – TRADING
Active managers can buy and sell without being constrained by prescribed intervals at which portfolio rebalance can take place.
ETF managers, because of the rules in the index, must rebalance an entire portfolio at prescribed intervals in order to deliver on replicating the index. When you consider the active buy and sell decisions that ETF managers need to undertake, at whatever market conditions prevail, it becomes evident that there is an active management element to index tracking, this excludes feeder fund ETF managers, but applies to ETF managers who have to physically replicate the index. In between these intervals ETF managers need to create or redeem index baskets which can be tricky as they have to be aware of the current weightings in order to avoid a mismatch of flows and index constituent allocations.
Market data systems, like Bloomberg and Reuters, are required by both Active and ETF managers, the same cost needs to be incurred by the managers and isn’t a resource that can be stripped away to save costs.
MODUS OPERANDI – STOCK PICKING
Active managers invest in human capital that researches and analyses companies. Analysts look at a range of instruments and make buy/hold/sell recommendations based on their understanding of the markets and portfolio managers implement this research in a manner that best suits the fund objectives. Active managers have the ability to time the market and buy when things are cheap and sell when there’s a profit to be made, although no manager can ever perfectly buy at the bottom of valuations or sell at the peak.
ETF managers have a predetermined set of companies in which to invest in, based on the methodology used by the index. The rules, when applied to a market data set, should be consistent in picking up the right set of companies consistently, with no deep analyses being required. The ETF manager implements the index rules to construct the portfolio and can anticipate changes to the company selections at the upcoming rebalances, if they understand the rules correctly. Many people think ETF managers over buy stocks when they are growing/expensive and over sell stocks when they are declining/cheap, this is not the case, when a constituent grows, the index adjusts to reflect this growth accordingly, same as when the constituent slips. This does not mean the ETF manager is buying stocks at high value and selling at low value, but rather the ETF manager is reflecting the gains and losses taking place in-real-time.
Fees are a favorite topic of debate in the Active vs. ETF manager debate.
Active managers apply skill and deploy resources to find opportunities that fit their philosophy and in so doing can beat benchmarks set for their portfolios. This allows the Active manager to charge higher fees for finding alpha.
ETF managers undervalue the amount of work they actually do, particularly when they have constructed the index in-house and also physically replicate the holdings of the index in their portfolios. ETF managers deploy technology and a network of external stakeholders to replicate the indices they track. Resultantly ETF managers charge lower fees as the ongoing cost of rules based investing should be relatively lower than human capital cost required to find alpha.
Currently ETF managers run the risk of creating price wars, in an attempt to stick it to Active managers when, just like budget airlines, they too have to pay the same cost to fly in the sky.
WHAT TO LOOK OUT FOR
Active managers are assessed on their investment philosophy, the calibre of the investment management team, the track record of the portfolios, the portfolio performance relative to the benchmark, the fund size, and a much more exhaustive list than these mentioned items.
ETF managers have never really come under that much scrutiny, however one always needs to consider the following elements:
- The index rules for the ETF, how are constituents are selected, how the markets traded are selected, how are corporate actions are treated, how often does the rebalance take place, is that sufficient, and everything else found in the index ground rules. One thing all ETF issuers publish is their low fees, one thing they to forget sound blast is the index ground rules, which in essence is their investment philosophy.
- Off the shelf vs. custom indices, not all market capitalisation indices are bad, before veering off and believing smart-beta is a way for ETF managers to outshine Active managers. When an index is custom made it means there was no index suitable enough for the ETF manager’s investment philosophy. The custom index is built ground up by the ETF manager, which means the stock universe and constituents require a thorough stock analysis at the onset, something which is often overlooked when it comes to ETF managers.
- Tracking error is one of the fundamental ways to measure the performance of an ETF manager. At the end of the day the ETF manager needs to replicate the index, so a lower tracking error is preferable. There are a few formulas for calculating a tracking error:
- the sum of the difference between the ETF holdings and index constituent weightings (best used),
- the standard deviation of the returns of the ETF and that of the index, over a given period, (technically used) and
- the difference in return of the ETF net asset value and the return of the index, although some may make it the difference between the performance of the listed ETF price (net asset value + spread) and that of the index. (inconsistent use)
WHAT NOT TO LOOK OUT FOR
Active managers tend to assign benchmarks to their portfolios which are easy to beat. This can distort the “true-to-strategy” view in lieu of over-weighting the out performance criteria in the assessment of an Active manager’s portfolio.
ETF managers are often judged on fund size which is not correct. An ETF is, effectively, its underlying, as prescribed by the index, and an ETF manager provides a point of entry and exit for that underlying. When talking about fund size ETF managers should be looked at from the perspective of the underlying, imagine a world where an ETF issuer quotes their fund size as the market capitalisation of the index. ETF managers have a track record that precedes them, which is the history of the index they track, not necessarily the amount of time they’ve being around.
Historical performance is a great way to compare managers, however its important to read performance in conjunction with the managers philosophy.
Cloud Atlas investing is an ETF manager that offers specific exposure to the Pan African growth prospects. It is far from a passive business, from developing the AMI Big50 index internally and outsourcing the calculation to Thomson Reuters, to physically trading stocks across the African continent and managing them in line with replicating the index, it easy to see the active elements in managing an ETF. When picking an active manager there are a host of philosophies and styles to choose from, much like picking an index to allocate to. The fact that there are only 7 ETF managers in South Africa and thousands of Active managers to choose from puts ETF managers in a niche bracket, which is what Asset consultants are best suited to unpack.