How ETFs turned the old passive/active debate on its head

The world of ETFs continues to evolve and appears to be gradually drifting towards what the early listed index funds opposed at their inception: the world of active funds management. What is this trend all about?

What an increasingly obscure partner an ETF is in the active versus passive debate that has been going on since the 1980s. Suddenly, all the rhetoric of ETFs providing retail investors with liquid low-cost access to indices has been replaced with a sophisticated argument that ETFs are, in fact, a more intelligent way of getting ‘outperformance’ for lower fees compared with traditional active management. Who saw that coming?

It’s all about old buzz words becoming fashionable again and ‘smart beta’ tops it off. But, surely, these jargon-like headlines are all about marketing? As if anyone wants non-smart investments? But ‘smart beta’ sounds a lot more attractive than ‘risk premia’ or ‘factor investing’, which are pretty much the same thing.

It’s actually an exciting development. Today, investors are invited to not only take advantage of traditional simple passive ETFs but also dip into the opportunity to slice and dice indices. For example, out-of-cycle sectors, involving underperforming stocks, can be excluded. And direct investors in listed stocks can access a whole new world of professionally managed investment strategies.

It sounds clever, is clever and, ironically, may be the way of the future if it’s rebranded ‘digital funds management’. There’s a thought: let’s call it digital funds management’. You heard it here first.
But the trend does challenge the original argument of low-cost passive being the most effective long-term creator of wealth. The world’s pioneer of passive – Vanguard Investments, founded by the great Jack Bogle – now offers active ETFs in Australia, as do the other big providers. How confusing is that? If the now-retired Jack Bogle was dead, he would turn in his grave.

One has to ask whether it’s really more about asset gathering than asset management or whether it’s just the progress of science and a subtle, more sophisticated argument. Time will tell if philosophical belief matters, but for true-blue bloods in stock selection, it certainly feels hollow to the core.
The change does, however, introduce increased complexity for robo-platforms that use passive-only ETFs and for advisers using a disciplined rebalancing program solely with ETFs whether the asset allocation is dynamic or strategic.

It also brings an element of hypocrisy to the debate that active doesn’t work. The issue is that when blending smart beta ETFs with passive ETFs a subjective call is being made that use active assumptions. Further, when a portfolio is constructed by a manager or adviser using ETFs that access, say, small caps, then the top 200, minus the top 20 etc., it’s a call involving selective timing against an index. The debate becomes half pregnant.

Passive works – I’m not saying it doesn’t – and so does active. But being clever enough to market time certain sectors using smart beta ETFs and so on seems a bit of a nonsense if investors are, at the same time, criticising active managers that use traditional stock selection. It’s exactly the same philosophy with different tools of trade.

The real debate /opportunity with every diversified portfolio is that almost all portfolio construction tools work when applied judiciously with discipline overtime. This includes blending passive with active and vehicles such as ETFs, managed ETFs and so on. These are implementation tools. There is no one single solution and there is no right or wrong with preferred methodologies.

What does seem to be happening, though, is that active timing or ‘predictive forecasting’ as some would prefer to call it, is alive and well in portfolio construction even in the world of ETF portfolios.
With the ETF market seductively, at first, being sold on low-cost and passive strategies, we are now heading to a mid/high cost active ETF world and a changing mid-cost scenario with pure active managers. The gap is closing and maybe the interesting dynamic is the touch and feel of human relationships versus the opaque tools of trading and algorithms.

That’s an interesting debate in the world of digital platforms and artificial intelligence when muddled with the great human characteristics of greed and fear. Do we run with the robots or revert to the tactile feeling of dealing with people when it comes to our retirement security? Change is never easy… and trust is earned.

First published: 14 March 2018

*Written by Ian Knox. The views expressed are his own.