Is Index Investing Extinct?
active management, exchange-traded product

An article in Forbes laments a recent change of focus in ETF industry conferences from traditional “market-tracking” products to active investment strategies. By “market-tracking,” the author clearly means the classic market-cap weighted indexing that is prevalent in ETFs.

This brings up two questions. The first one: What really qualifies as active management? A one-time decision to invest in the entire stock market, such as through the Vanguard Total Stock Market ETF (VTI), is arguably an act of active management. So is a decision to split the investment portfolio between 60% VTI and 40% iShares Core Total U.S. Bond Market ETF (AGG). Likewise, a decision to adopt

“a fixed asset allocation to various asset classes based on an investor’s long-term needs.”

Periodic portfolio rebalancing to such a fixed allocation is also a form of active management, if not market timing, even if conducted on a fixed schedule. That is because one of its attributes is to “buy low, sell high,” i.e. lock in the gains in appreciated assets to cheaply purchase other assets in anticipation of a reversal to the mean.

Similarly, any modification of a “fixed” asset allocation in response to a change in the investor’s age or life circumstances also qualifies as active management.

Finally, it is worth noting that indices tracked by passive ETFs are also actively managed. Over time, the membership of securities in the index will change, and frequently so due to an arbitrary decision from a management committee rather than as a result of an explicit formula. A recent recomposition of the Dow Jones Industrial Average is one case in point. Another example is a recent switch of the Vanguard Emerging Markets ETF’s (VWO) underlying index from MSCI to FTSE, which caused all South Korean stocks to be removed from the fund.

Active management inevitably takes place at all stages of the investment process, even one based on passive instruments.

The second question that arises: Where is the ETF industry heading? The first wave of ETFs was about attaining economies of scale while implementing traditional market indices. It created a few dominant providers but resulted in a race to the bottom in management fees.

The second wave was about spreading horizontally to all niches of the market. Many of such exotic strategies failed to garner minimum assets of $50-100M that are typically required for an ETF to survive.

The third wave is about non-market-cap indexing, whether equal-weighted or fundamentally-weighted (“smart beta“). Such funds are a blasphemy to market-cap indexing purists who spend a lot of time poking holes in these strategies.

The next wave, pending regulatory approval of infrequent reporting of fund holdings, will be about active management. The ETF structure is attractive to actively-managed mutual fund vendors because it allows them to lower fees and survive the onslaught of cheap market-cap indexed ETFs.

All this makes traditional fee-based advisers nervous:

In the end, most advisers continue to do what’s in their clients’ best interest; they create a long-term asset allocation, buy low-cost index fund, and then stay the course!

The problem is that in many cases investors pay a recurring annual fee of anywhere from 0.2% to 1.5% of assets for a one-time setup of a portfolio pie-chart (frequently with small variations from the adviser’s “moderate” allocation template), followed by periodic rebalancing and reports. That enables a typical adviser to spend only about 11% of time on investment research, while devoting about 18% to client acquisition and prospecting, and 48% to client management.

In the end, the market will rightly decide what type of financial products survive and flourish. Marketing gimmicks aside, innovation in the ETF industry is a good thing because it gives investors more financial instruments to choose from at an ever-decreasing cost. Alpholio™ can use these new products to form reference ETF portfolios that better explain the performance of actively-managed mutual funds and arbitrary portfolios.

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Urban Myths of Mutual Funds
active management, mutual fund

A recent article from MorningstarAdisor discusses an urban myth that mutual funds have hidden fees of 140-200 basis points (bps), which are omitted from expense ratios. In this context, the article provides the following statistics:

Over the trailing 10 years ending March 31, 2013, the average U.S. large-cap equity fund, on an asset-weighted basis, trails the market index by its expense ratio plus about 39 basis points. Over the past five years, this figure shrinks to 25 basis points.

This means that an average large-cap fund not only failed to earn its expenses but also subtracted value on top of them. By how much in total? The Investment Company Institute’s report provides the following asset-weighted statistics of expense ratios for equity funds:

All Funds Actively-Managed Funds Index Funds
2003 100 bps 110 bps 25 bps
2008 83 94 17
2012 77 92 13
10-Year Average 87 98 18
5-Year Average 82 95 15

So, an average large-cap equity fund subtracted about 98 + 39 = 137 bps and 95 + 25 = 120 bps per year in the 10-year and 5-year periods, respectively. The non-asset-weighted statistics of fund expense ratios are even worse (all figures for 2012):

Equity Strategy Median Mean
Aggressive growth 137 bps 147 bps
Growth 124 131
Sector 146 153
Growth and Income 112 118
Income 112 120
International 147 155
Average 133 141

Of note here is the right skew of the expense ratio distribution (in all cases, the mean is greater than the median). This implies that some funds have very high expense ratios. Indeed the 90th percentile of equity funds has an average expense ratio of 216 bps or more, which is over 62% higher than the median of 133 bps.

Apparently, all this was not lost on he California Public Employees’ Retirement System (CalPERS), which this week decided to replace actively-managed strategies with passive ones even for asset classes other than equities:

The $1.64 billion defined-contribution plans, including the $1.1 billion 457 plan, will be adding passively managed U.S. equity, international equity, short-term-bond, intermediate-term-bond and real-asset strategies from State Street Global Advisors.

The investment committee elected to drop actively managed U.S. small- and midcap value and growth strategies managed by The Boston Co. Asset Management LLC, international equity managed by Pyramis Global Advisors, short-term bond managed by Pacific Investment Management Co. LLC, and intermediate and Treasury inflation-protected securities strategies managed in-house.

Fees for the funds will drop to 6 basis points, from 52, because of the change.

Evidently, even with an average expense ratios of 52 bps (which is close to the 10th percentile for actively-managed funds), original strategies failed to earn their keep.

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