The massive money flows into passively-managed mutual funds and exchange-traded funds (ETFs) cannot be denied.
Over the past year, fund flows into active equity funds were negative across the board while the flows into passive surged higher. Bonds were the only actively managed funds with substantial inflows over the past year.
Our answer to the active versus passive debate?
There are too many investment products that should not exist. Why? Because there is little chance of meeting the investor’s desired outcome. In addition, many “active” funds are “closet indexing.” That is, the manger is not making the portfolio different enough from the benchmark to outperform. Finally, fees are often out of alignment with the value provided.
On average, actively managed funds “work” for investors if fees are reasonable, the portfolio is unique to the benchmark, and the manager has their own money invested alongside the end investor.
It is ‘buyer beware’ though for knowing which index and ETF to purchase if the decision is to go passive.
Three well known index providers have very different ways of building an index. Below is a study for Standard & Poor’s, Russell, and Dow Jones. Each has a core small cap index. The overarching goal is the same; tracking companies below $2.5 billion in market size.
There are a different number of constituents in each index ranging from about 600 to 2,000. Each has different metrics for including companies, such as fundamentals like profitablity to liquidity. There are multiple frequencies for when each index changes the constiutents. Each has its own way of treating IPOs. The results for the last 15 years of the three widely followed indices are below.
Source: Zephyr StyleAdvisor
If one were picking which index to track 15 years ago, the Russell index underperformed the Dow Jones by a massive 76%! That is 1.5% per year just for picking a different index! The S&P 600 only slightly lagged the Dow Jones Total Small Cap Index by 0.12% per annum, or 6.5% cumulatively. This is not to say the pattern will hold for the next 15 years, but it sure is good to know this, and the reasons why.
With hyperactive growth of passively-managed assets, understanding these aspects is key to selection.
Another example where making a passive choice is more difficult than it seems is fees. One asset manager provider has two ETFs tracking the same emerging markets index. The difference? One costs over four times as much! And surprisingly, the more expensive ETF has $30 billion in assets compared to $28 billion for the cheaper one. Traders and large institutions own the more expensive one due to the greater number of shares traded daily. Buy and holder investors could also unwisely own the more expensive fund if they do not do their homework to know what the market price is for an emerging markets index fund.
Just because an investment product passively tracks a benchmark, it does not mean the investor’s due diligence should also be passive.
“Know what you own, and why you own it.” – Peter Bernstein
This material is based on public information as of the specified date, and may be stale thereafter. Aurum Wealth Management Group has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates.