A front-page article in The Wall Street Journal recently reported that $124 billion has poured into ETFs in fewer than 60 days. These ETF flows are the strongest start to a year ever1. If this rate continues, ETFs will capture about three-quarters of a trillion dollars this year in the U.S.
ETFs keep growing fast because traditional security-selection active management frequently struggles to perform. We all know the story. First, traditional active is expensive. Second, over the long-run, few if any traditional active managers deliver enough performance to offset their cost. Third, the opportunity for success from picking stocks is getting smaller, in part due to the impacts of technology and capital market innovation. Fourth, because active managers tend to hug the index, they seldom get investors out of harm’s way – as people had (wrongly) assumed they tried to do. And fifth, it has long been known that 90% of portfolio return variability depends on where you invest not which securities you select from within exposures2. With a huge array of ETFs investors can get more benefit through holding a diversified global multi-asset portfolio of ETFs. This, coupled with the radical transparency of the Internet, makes traditional active seem doomed.
Many pundits describe this as “the transition from alpha to beta.” But that oversimplifies the trend. It is wrong to assume investors are simply shifting to buy-and-hold strategies that were formerly associated with index funds. We believe the shift away from traditional active is a complex shift to additional asset classes, additional regions, and ideas like smart beta.
Many pundits describe this as “the transition from alpha to beta.” But that oversimplifies the trend.
This tectonic shift toward ETFs raises a number of new challenges. At 55 Capital, we describe this as the “need for active management of passive exposures.” What is needed takes many shapes and forms, and in some cases, raises issues that didn’t appear before.
Here is my list of the major ones:
Who is going to shape the “base” portfolio?
You can agree or disagree with the basic idea of cap-weighting, but it provided a great simplifying guideline for portfolio construction: if large-cap is 70%, mid-cap 20%, and small-cap 10% of the stock market, you have a basic blueprint to work with.
Once you add more asset classes, we believe cap-weighting as a guideline makes little sense. We already know this from bonds, where no one holds them in relative market weight. The balance of stocks and bonds in the market has nothing to do with relative value; it is a creature of the non-market forces of corporate finance, tax policy, and regulation (many institutions like insurers can’t hold equity even if they would like to). The same holds true for foreign markets, where the equity market may be huge, but a small part is publicly listed. Once more, cap weight is of little help. And, with today’s ETFs, you can also get exposure to commodities, currencies, and other alternatives (maybe even BitCoin soon). What is their “right” weight?
Strategies like 60/40 exist because we needed some rule for mixing stocks and bonds. But when you add in foreign exposures, currencies, etc., a new calculus of portfolio weighting is needed.
Who is going to regularly manage risk and market dynamics?
People used to believe traditional active managers not only caught the upside, but also moved to safety at times of risk. But most traditional active managers try to stay fully invested at almost all times because they are judged on relative performance. If their sector goes down, they don’t underperform by going down with it; but if their sector rockets up when they are in cash, they grossly underperform and lose customers and revenues. At a time when investors are fleeing active overall, it is very costly to try to replace ones who have left dissatisfied.
But unless you are just willing to ride the waves as they come, someone somewhere needs to make the frequent decisions about when to dynamically reallocate across positions – and when to move to safety (like cash and gold) when markets are choppy. A deep knowledge of global markets is required to do this right.
The good news is all this can be done with an ETF portfolio. The bad news is that few investors are set up to do this in a systematic, reasoned way across global stock, bond, and alternatives exposures. And, once again, there aren’t widely known rules of thumb we can all use.
Back when ETFs were a small part of many portfolios they often served as a placeholder. What happened if you didn’t have a domestic small-cap active manager you liked? Putting that 5% of the portfolio into a Russell 2000 Value ETF was an easy solution. Ditto for emerging markets, commodities, etc.
When ETFs were a condiment and not the main course this was fine. But no more. ETFs continue to steal the lunch of traditional active managers, which I think is warranted. But this is not a shift to “passive” investing. Rather, it requires a new set of ideas, tools, and approaches to effectively manage these “passive” exposures.
This is what we spend all our time on at 55 Capital. It is crucial work because the answers are still being developed for navigating this ETF-heavy world. And it is no small task: we often liken this to shifting from playing checkers to three-dimensional chess. But in a world where ETFs are growing at a rate of nearly a trillion dollars a year, it is crucial that it gets done and gets done right.
Because the world is not becoming passive: it is becoming active in a new and more useful way.
For more information, please visit 55 Capital Partners here.
1 Source: The Wall Street Journal, “Small Investors Run to ETFs,” March 4, 2017.
2 Source: CFA Institute, Financial Analysts Journal, “Determinants of Portfolio Performance,” 1986.
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