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The Future Transition Towards Passive Investing and Exchange Traded Funds

The End of the Stock Picking Era? Or a Grand Opportunity?

Passive Investments on the Horizon

There is no denying that a shift in the financial products industry is on the horizon. The explosive growth of exchange traded funds (ETF) over the past few years has taken the structured product to new heights. The shift has been so powerful in fact that since the year 2000, the percentage increase in assets committed to ETFs has grown by over 2,500%, compared to an increase of only 120% for mutual funds¹. Although the total invested capital in mutual funds still triumphs ETF by tenfold, this spread is likely to diminish with new investor preferences. There are two main driving forces behind the growth of ETF’s:

  1. Underperformance of Mutual Funds – Many mutual funds have failed to provide superior returns above their state benchmark. Coupled with this underperformance, clients are paying management expense ratios (MER) of 2% or higher. This has ultimately led to client’s abandoning the mutual fund and switching over to ETF’s. Not only do clients pay a lower fee, but they also generate the same or better performance of many of the mutual funds in Canada.
  2. Fee Compression – When products become commoditized the only variable is price. Mutual funds today have become relatively indistinguishable from one another. Although they may invest in slightly different assets there performance is relatively similar (this is due to closet indexing which will be touched on later). The pressure from clients to lower management fees charged by mutual funds has been growing. Investors are seeking cheaper, low-cost places to hold their money and many resort to ETF’s as the answer.
  3. The shift towards ETFs has been particularly powerful in the US, where assets stand at almost $2.8 trillion at the end of March 2017, compared to the $16.9 trillion US mutual fund industry, according to the Investment Company Institute². Sanford Bernstein, a research house owned by the asset manager AllianceBernstein, recently predicted that by January next year more than 50% of equity assets under management in the US will be passively managed.

     

    The Great Eclipse

    Number of US Funds and Stocks

    The Graph above illustrates the number of mutual funds, stocks and ETF’s on a specified time horizon. As the numbers of mutual funds have plateaued, the growth has been transferred to ETF’s, to which there are almost now 2000 funds. There is nearly universal consensus that the ETF industry will continue to grow at double-digit rates for several years to come. Many analysts predict the ETF industry will surpass the hedge fund industry in assets under management (AUM) in the very near future³.

    As the popularity of ETFs grow, it will eventually distort the market.

     

    TSX Listings By Type

    THE GLOBE AND MAIL,SOURCE: TMX GROUP & AUTHOR’S CALCULATIONS / LISTINGS AT YEAR END

    Although ETF’s may be years away from reaching the level of AUM that mutual funds currently have, their growth and competitiveness in the market is undeniable. So, if ETF’s are slowly eating away at the market share of the mutual fund industry, what implications does that have on the overall markets? And what happens to active managers?

     

    Active Investing: Eradication or Survival?

    ETF’s are products that essentially track a specific index, because all of the holdings are to the exact weighting of the index. This passive investment strategy forgoes stock research, as investors take the returns as given. With more and more people converting to ETF’s and its passive management style, the amount of stock specific research diminishes. Fewer analysts and people would look into the fundamentals of specific stocks and market inefficiencies would soon start to develop. Stocks would become severely mispriced. The dissemination of available information into a stock’s price would be diluted due to the high presence of passive investors.

    Another daunting issue that arises if a majority of investments are passive is market liquidity. Since ETF’s are not actually physically shareholders of all the stocks that compose there fund, they do not contribute to market liquidity. Thus, in a world of ETF’s the liquidity of individual securities would vanishes as investors would only trade indices. With the abandonment of active management and lack of liquidity the secondary market becomes a riskier realm, and thus would raise the cost of financing new companies in the primary market (Lasse Pedersen).

    “If you pushed indexation to the very logical extreme you would get preposterous results.”

    -Berkshire Hathaway’s Charles Munger

    It is for these two reasons (Liquidity & Market Efficiency) that active management can never disappear. The impact of active management is imperative in maintaining the efficiency of modern capital markets.

     

    The Opportunity of the Transition

    As explained above, as more and more investments are transferred to passive strategies the amount of bottom up research diminishes. With analysts gathering less information and trading fewer stocks, securities become mispriced. The discrepancy between the current value and the intrinsic values widens, and this creates a substantial opportunity for the active investors like Verus Financial. Large mispricing means more room from appreciation and thus larger returns. When larger inefficiencies develop in markets, the prospect of greater returns grows. Thus, if indexation takes over a majority of the investment community, active managers such as Verus are able to capitalize on these mispriced assets.

     

    Mutual Funds Coming Out-of-the Closet?

    Although the growth of ETF’s is slowly pushing the investment community towards indexation, another major concern is the abundance of “Closet Indexers”. A closet indexer is a fund that portrays an active management style, when in reality it closely tracks a specific benchmark. It is estimated that around 40% of all mutual funds in Canada are closet indexer4. This number is even greater when comparing US mutual funds. Therefore, in reality the amount of investment funds that are index derived are far greater than what the general pubic suspects. The only positive of closet indexer compared to ETF’s is they promote liquidity, as stocks are physically bought and sold. Luckily for the investor community the Ontario Securities Commission stated that it had “commenced a targeted review of conventional mutual funds that disclose in their prospectus and marketing materials that they pursue active management strategies … Among other data, we considered the funds’ active share (a measure of the percentage of a fund’s portfolio holdings that differs from the composition of its benchmark index) to assess the extent of active management.”5. For more information on Closet Indexing please refer to our SMA guide for a detailed analysis.

    Understanding SMA – Separately Managed Accounts

     

    Why Conventional Money Management and ETF’s Don’t Work:

    Anyone that has talked about finance or investing has probably heard the old adage “Don’t put all of your eggs in one basket.” It is true that diversification is necessary to help eliminate the risk of any one asset declining, but when there are too many eggs in the basket, this has an effect called diworsification. At what point does it start to actually have adverse effects from holding too many securities?

    In 1968, the findings of John Evans and Stephen Archer along with Thomas Tole’s 1982 research demonstrated that “90 percent of the maximum benefit of diversification [was] derived from portfolios of 12 to 18 stocks.” Further, as the number of holdings increased to approximately 20, a gradual reduction in portfolio risk occurs. This concept is shown in the diagram below:

    standard deviation

    As stocks are added beyond the 20th holding the reduction in overall specific-risk becomes almost negligible. Thus, there becomes a point at which (around 30 stocks) the addition of a single stock has virtually zero impact on minimizing the risk of the portfolio. According to Warren Buffett, “Wide diversification is only required when investors do not understand what they are doing”. In other words, if you diversify too much, you might not lose much, but you won’t gain much either.

    K. J. Martijn Cremers and Antti Petajisto from the Yale School of Management released a paper in 2009 about their new measurement called Active Share (as mentioned above). They stated “An active manager can only add value relative to the index by deviating from it. Some positive level of Active Share is therefore a necessary condition for outperforming the benchmark” (Cremers, 2009). Through their research they found that “The best performers are concentrated stock pickers (high Active Share, high tracking error)”.

    Verus portfolios have consistently outperformed the market because of the two factors mentioned above. Verus portfolios are structured very differently from the market as a whole and are extremely concentrated.

    The idea that concentration creates wealth is of paramount importance. The key reason to why the majority of Canadian mutual funds never outperform the market is because they are positioned exactly like the market. One prime example is RBC Canadian Equity which manages $2.5 billion. The fund invests in 107 positions in the TSX Composite universe and has an active share ratio of 21.31% (closet indexer). Over a 10 year period the fund has an alpha of -1.51% and a beta of exactly 100%. Not only is this fund almost an exact replica of its benchmark, it charges an MER of 1.97%. This is just one example of the many Canadian mutual funds that execute a closet indexing strategy.

     

    Invest with Verus

    Sources:

    1, 3 Investopedia

    2 Financial Times

    4 Business News Network

    5 Globe & Mail

     

    http://www.bnn.ca/jennifer-radman-s-top-picks-may-9-2017-1.747022

    http://www.theglobeandmail.com/globe-investor/funds-and-etfs/funds/osc-to-examine-actively-managed-funds/article29004948/

    http://www.investopedia.com/articles/01/051601.asp

    http://www.advisorselect.com/transcript/ValueLine/concentrated-funds-benefits-of-a-focused-approach

    https://www.theglobeandmail.com/globe-investor/investor-education/diversification-how-many-eggs-how-many-baskets/article4171497/