Thoughts on ETFs vs. Actively Managed Funds

One of the remarkable trends of the last 10 years has been the growing popularity of exchange traded funds (ETFs) as advisers and the investing public have grown frustrated by their failed efforts to outperform the major market indexes. As returns continue to fall short of expectations and the prospect of subpar annual returns looms on the horizon, fees for actively managed portfolios are receiving greater attention than they would in a higher-return environment.

Under increasing pressure to reduce management fees, large purveyors of mutual funds have responded by offering ETFs with substantially lower fees than actively managed mutual funds, but which promise returns that closely mirror a selected market index such as the Dow Jones Industrial Average or the Standard & Poor’s 500 Index. This trend seems to be advancing at a pace that, at first glance, appears to doom the era of actively managed portfolios that has been the hallmark of the last 50 years.

With this in mind, it’s important to take a closer look at the investment management profession to ascertain the state of the industry and gain a better understanding of the risks and opportunities that lie ahead.

Despite broader use of passive index investments in recent years, driven by increasing numbers of ETFs, which now account for 35% of the dollar amount of US equity trading volume, many still believe that active portfolio management built on the tenets of the Graham and Dodd value investment philosophy is the best way to achieve solid investment results over time. According to research from Arrow Partners, a third-party marketing firm for asset managers, significant AUM continues to be raised within the active management space.

Reassessing Active Management Performance

Furthermore, recent academic studies from researchers K.J. Martijn Cremers and Antti Petajisto conclusively found that active portfolio managers can and do add value by outperforming their benchmarks, both before and after fees. Instead of using the historic approach of looking at tracking error alone, these researchers evaluated active management along two dimensions: tracking error and active share. Their findings were startling—and in direct contradiction to the long-held notion that active management underperforms. To quote Petajisto:

“In my study, I used active share and tracking error to sort domestic all-equity mutual funds into five categories on the basis of the type of active management they practice. I found that the most active stock pickers have been able to add value for their investors, beating their benchmark indices by about 1.26% a year after all fees and expenses. Factor bets have destroyed value after fees. Closet indexers have essentially just matched their benchmark index performance before fees, which has produced consistent underperformance after fees. The results are similar over the 2008–09 financial crisis, and they also hold separately within large-cap and small-cap funds. Economically, these results mean that there are some inefficiencies in the market that can be exploited by active stock selection.”

 This research showed that a full one-third of mutual fund assets were with self-proclaimed active managers that were, in reality, “closet indexers” that “hugged the benchmark” with low active share scores and stock positions that closely replicated their benchmark. With closet indexing on the rise since 2007, their inclusion within the active manager universe has skewed the performance of the entire active group, contributing to the misconception that active managers underperform. However, when closet indexers are eliminated from the active manager fund universe, the data clearly shows that active portfolio managers can and do outperform.

Given research by Cremers and Petajisto and others, concern that the stock market is no longer an efficient allocator of capital due to the growth of passive and quasi-passive products, which buy all the same stocks for the same reasons, and the fact that financial markets are moving from unprecedented stimulus and liquidity into a period of credit constraint and higher interest rates, we believe investors should be wary of investments based on quantitative factor-based backtests.

As quant funds tend to underperform when there is a fundamental shift in the market, especially during this period, market winners could be very different going forward in comparison to past winners, as stock outperformance could easily be confused with credit sensitivity. Due to the magnitude of this secular change, we believe the coming tighter-money regime screams for fundamental research, case-by-case human consideration of company prospects, and early understanding of company changes that will not be reflected in quant models until much later.

The Next New Thing

Accordingly, we are optimistic about a resurgence in active equity management and future demand for actively managed products. We believe that old-fashioned stock picking that emphasizes bottom-up research to identify companies with good long-term prospects selling at a discount to intrinsic value due to temporary dislocation and/or market mispricing will be the next “new” thing in asset management.

Within the environment that we foresee, those individuals who prepare themselves properly and are armed with the knowledge gained through completion of the rigorous CFA® Program will be prepared for the challenges that lie ahead. Importantly, it is our belief that the application of fundamental analysis built on the foundation of the Graham and Dodd value investment philosophy will produce competitive returns over the long term. 

About the Authors

Donna Renaud, CFA, has 30 years of financial market experience. For the past 12 years, Donna has been employed by Northern Trust Asset Management, starting as an analyst and portfolio manager for Northern Trust Value Investor and advancing to Managing Director of Northern’s large-cap value equity and large-cap value balanced products. Donna earned a BA with high distinction from Pennsylvania State University, and an MBA from Arizona State University, and holds the CFA designation.

Stephen K. Kent Jr., CFA, CIC, has over 40 years of experience in virtually every aspect of investment management. During his 15 years with Carl Domino Associates and its successor, Northern Trust Value Investors, Steve played a key role in the growth of assets from approximately $325 million in 1992 to $5.2 billion at year-end 2006. During the last five years of that association, Steve was Senior Vice President and Chief Investment Officer managing a team of nine portfolio managers. Steve is a graduate of Washington & Lee University. He holds the CFA designation, served as President of the Philadelphia CFA Society, and is a member of the Los Angeles CFA Society.