Active ETFs are all the rage. But, says ROBIN POWELL, they have a major design fault that should put you off. The clue is in the name.
“First they ignore you, then they laugh at you, then they fight you, then you win.” Whoever it was who said or wrote these wise words (apparently it wasn’t Mahatma Gandhi), they could well have been writing about the triumph of passive investing.
I’ve been writing about this historical inevitability for 13 years, and I’m pleased to report that the ignoring and the laughing phases are finally over. UK fund houses are haemorrhaging assets and starting to hurt. Abrdn announced in January that it’s cutting 500 jobs, and since then other firms have announced they’re reviewing costs, all of them citing the pressure of competing with low-cost index funds.
After years of complacency, the most diehard apologists of active management have at last woken up to the existential threat the industry faces. Even the former head of research at Hargreaves Lansdown and Neil Woodford cheerleader Mark Dampier has now admitted he underestimated the challenge that passive funds pose. “I think many of us were fooled into thinking they weren’t that important,” Dampier confessed, although he still couldn’t resist a dig at what he called “passive smugness”, instantly bringing to mind the words pot, kettle and black.
ETF wars
So we’re now in phase three — the fight itself — and you only need to look at what’s happening in ETFs for proof. So far this year, BlackRock, JPMorgan, BNP Paribas and Ark Invest have all rolled out actively managed ETFs for European investors, and many other active managers will follow suit. According to the consultancy Blackwater, 92 percent of European fund managers plan to either launch, or consider launching, ETFs within the next two years.
How quickly things have changed. For years, fund management companies sneered at ETFs, but they suddenly seem to have become their biggest fans. Why? The main reason, surely, is obvious. There’ve seen huge inflows into active ETFs in countries including US, Canada, Australia and Korea, and they now want a slice of the action (or, more to the point, the fees) themselves.
But there’s another reason for active managers to embrace ETFs, and that’s to wipe clean the performance slate. If you run a mutual fund with a long record of lagging the market, washing away that underperformance by relaunching it as an ETF is enormously appealing.
There are some indexing advocates who have a downer on ETFs. Even Jack Bogle expressed dislike for them, although he did admit, in the final interview I did with him, that he had, on reflection, been a little too dogmatic on the issue.
ETFs are just a wrapper
I certainly have no gripes with ETFs. They were a welcome innovation for consumers when they first came out. They gave ordinary people a cheap, easy and efficient way to gain exposure to entire markets.
The biggest issue Bogle had with them was the option for intra-day trading, which he felt encouraged people to trade them. I can see his point, but assuming you have the discipline to hold your passively managed ETF for a very long time I personally don’t see an issue.
The problem, then, with active ETFs is not that they’re ETFs but that they’re active. As the investment author William Bernstein once put it, the ETF is ultimately just a wrapper, and launching an active ETF is like putting bad fish in a pink wrapper instead of blue one. It certainly won’t mask the smell.
To put it another way, and with respect to my home town football club, kitting out the Burton Albion in an Arsenal strip won’t magically make them play like title contenders.
The hype around active ETFs, in other words, is just a distraction from the bigger issue — the inherent inferiority of active funds. I’m not expressing an opinion there incidentally, but stating a mathematical fact. As Bogle liked to remind us, “the net return is the gross return minus the cost of playing the game.” Active ETFs, though cheaper than other active funds, are still much more expensive than passive ETFs. So the average active ETF investor has to underperform the average passive ETF investor; it’s simple arithmetic.
A busted flush
Demand for active has been strong worldwide, and I expect that to continue. But for how long? I do see a role for active ETFs of the systematic, or rules-based, variety; they do have a good chance of producing excess returns for investors with sufficient patience.
But traditional active stockpicking is a busted flush, and, unless firms reduce their fees dramatically, a change of wrapper won’t do anything to change its fortunes.
So pull up a ringside seat. We’re in for quite a fight in ETF land, But remember, there will only be one winner.
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