The Death of Active Managers

The Rise of ETFs: What You Need to Know

Given the tremendous growth in investing through Exchange Traded Funds (ETFs) in recent years, AAM has prepared a three-part series of articles aimed at providing investors with everything they need to know about ETFs.  In this first instalment, we explore the reasons behind this incredibly disruptive trend as investors shift away from actively managed funds and into passive investments.

Part One: The Death of Active Managers?

Twenty years ago, outside buying direct stocks and bonds, the main route to financial markets for investors was to place their money into managed mutual funds (unit trusts) and their faith into a dedicated fund manager.  As these fund managers are tasked with the responsibility of making investment decisions and therefore performance, they levy a management fee.  This fee, when added to the other costs of running a fund can amount to a total expense ratio (TER) of around 1 – 2% of the value of the fund per year (note: these charges are taken before publication of any unit price or performance data).  Because this approach relies heavily on the fund manager’s ability to identify sound investment opportunities, buying and selling assets when judged prudent, it is usually referred to as active investing.

Active investing had been established as the de facto standard for decades until the economic turmoil resulting from the Global Financial Crisis in 2008 caused many investors fundamentally to re-evaluate what they were paying for, as the value of their investments fell so dramatically despite the management fees charged.  This disillusionment with active investing has led to the proliferation of passive investments – low maintenance, index-based investments such as Exchange Traded Funds (ETFs).  Such investments are designed to “passively” follow the market rather than trying to beat it. The incredible growth of these investments is shown in Figure 1.

Figure 1: Significant Growth in the number of ETFs and the Value of Assets Invested in ETFs, Source: ETFGI

Are Active Managers Worth Paying For?

The argument for active investing relies on the ability of the fund manager to add value, that is, to generate a return sufficiently higher than a benchmark reference point (e.g. an equity index) to justify the management fee they charge.  In the case of an investor holding a UK-focused equity fund, we could compare the returns generated by the fund to the return on the FTSE 100 index (a measure of the return of the largest 100 companies that an investor can buy on the London Stock Exchange, weighted by market capitalisation).

Given the investor is paying for the fund manager to find the best opportunities, he or she would expect the managed fund’s returns to be better than that of the index by at least the 1 – 2% TER cost of the fund.  In other words, the investor requires a positive relative return on the fund to justify the additional fees paid.  If the fund made a gain of 5% but the FTSE 100 returned 10% over the same period, the investor should feel disappointed.  Conversely, if the fund made a loss of 5% but the FTSE 100 benchmark dropped by 20%, he or she might feel the fund manager had done a good job – at least in relative terms.

Beating the Benchmark

Much work has been done to try to understand whether actively managed funds are actually worth paying for.  While a consensus is yet to be reached, there is growing evidence that suggests it is very hard for active managers to sustain returns above that of the index.

The idea that actively managed funds cannot consistently beat the benchmark has furthered the popularity of Index funds and ETFs.  ETFs have enjoyed incredible levels of growth as effective ways of accessing markets such as the S&P 500 in the US or the FTSE 100 in the UK, where the efficiency of the market makes it extremely difficult for a fund manager to find mispriced stocks. They have also become very popular as a way of tracking commodities, currency pairs and even the amount of volatility (i.e. risk) in the markets.

What’s the difference between an Index Fund and an ETF?

An index fund is a passive investment, but structured in the same way as a fund.  New units are created by the fund house (and cancelled) as new investors buy (and sell) the fund. However, an index fund employs no fund manager and merely tries to replicate the returns of an index or benchmark.  As they do not employ a manager, or a team of analysts, they tend to be much cheaper than managed funds. ETFs are like index funds although they are traded like common stock on stock exchanges.  When you buy, or sell shares in an ETF you will usually trade with either another investor or a market- maker rather than the ETF provider.

Coming Out of the Closet

Another criticism of active managers is that of ‘benchmark hogging’, investing in a way which is similar to the index or benchmark that performance rarely deviates significantly from the index.  This might result from the compensation structure of fund managers, which is pegged to relative performance.  Achieving returns similar to returns on the index may ensure consistent financial rewards for the fund manager, but not for the investor.  Considering actively managed funds are more expensive, if performance is likely to be very close to the index then many would prefer to stick to indexes.

A Future for Active Managers?

Index-based investments like ETFs have caught the imagination of investors, who have recognised that through passive strategies, they may beat the returns available through managed funds, after taking fees into consideration.  And as ETFs become increasingly prevalent the same investors are becoming increasingly cost-sensitive.  Morgan Stanley reported that historically fund performance was the primary driver for trade flows but this trend has weakened, with fee levels becoming the more important factor.

With this in mind, the future for active managers does not look particularly bright.  However, at the same time, market spectators are increasingly aware of the shortcomings and potential risks involved with investing blindly in ETFs, as well as the opportunities for active managers to profit from such shortcomings.  This is explored in greater detail in Part Two of AAM’s ETF series.

Disclaimer: 

The views expressed in this article are those of the author and do not necessarily reflect the views of AAM Advisory Pte Ltd. This document/article should not be construed as an offer, solicitation of an offer, or a recommendation to transact in any securities/products mentioned herein. The information does not take into account the specific investment objectives, financial situation or particular needs of any person. Advice should be sought from a licensed financial adviser regarding the suitability of the investment product before making a commitment to purchase the investment product. Past performance is not necessarily indicative of future performance. Any prediction, projection, or forecast on the economy, securities markets or the economic trends of the markets is not necessarily indicative of the future performance. Whilst we have taken all reasonable care to ensure that the information contained in this document is not untrue or misleading at the time of publication, we cannot guarantee its accuracy or completeness.