Introduction
Market-Cap-Weighted and Smart Beta ETF Assets ($MM)
Source: ETFGI
The rapid inflow of assets into active/factor ETFs is likely to eliminate—and perhaps even reverse—
historical performance relationships supporting factor ETFs. Institutional investors are also using ETFs to quickly
express market opinions on a large scale without the time and liquidity constraints of selling and buying
individual securities. Rapid shifts in ETF fund flows between sectors and industries and various markets can
increase within-sector volatility and create wider dispersion of returns across sectors. This should create more
opportunities for active stock pickers.
Passive ETFs Risks Remain
The risks posed by factor ETFs are quite evident. But even the theoretical argument for passive ETFs,
to which we have given much more credence, fully holds only under a committed buy-and-hold philosophy
across complete market cycles. From a market timing perspective, the current U.S. stock market environment
appears particularly unsuitable for a passive investment philosophy. Market-level valuations are at the highest
levels since the dot-com bubble, whereas corporate profit margins are simultaneously at record highs. Value
stocks have also largely underperformed growth stocks for years, including ~1,100 bps underperformance by
S&P 500 value stocks versus S&P 500 growth stocks YTD (through 9/30/2017). Correlation between stocks in
the S&P 500 has plummeted since the November 2016 election, reaching lows not seen since 2001 and
creating—at least temporarily—a true “stock picker’s market.” These conditions tend to develop as bull markets
reach their limits (2000, 2007). As should be no surprise to market historians, investors are rushing into ETFs
just as the market appears to be diverging and a majority of active fund managers are outperforming (54% in
1H17).
ETFs’ liquidity advantage also introduces its own risks. It is difficult to quantify the impact, but ETFs
appear to exhibit outsized volatility in market corrections as their ease of trading makes them a prime source of
liquidity. Advisors have historically tended to act as an additional buffer limiting individual investors’ instincts to
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Introduction
withdraw funds during
market downturns, but the shift to roboadvisors and ETFs is likely to lead to faster
withdrawals during the next major downturn. According to
Business Insider
, roboadvisors are defined as
“automated investment platforms that use algorithms to manage and allocate investor’s funds, analyzing each
customer’s current financial status, risk aversion, and goals.” This relatively new phenomenon has quickly
achieved massive scale, fueled by both technological innovation and an increased appetite for passive investing
products. According to an analysis by Aite Group, the currently more than 2,000 roboadvisors have more than
$140 billion in AUM, up from just $3 billion in 2013. AUM growth for this category is expected to remain robust
for the foreseeable future. However, the newness of the automated roboadvisor approach also means that its
performance and capabilities have yet to be tested by a significant market correction. Like most passive
products, roboadvisors typically offer fees that are materially below those of more traditional actively managed
alternatives. Yet there is a trade-off for these lower fees, as considerations such as investor education and
general guidance for decision making may receive less attention than accounts managed by more conventional
financial advisors. Consequently, this newly created market segment may have produced an entire class of
consumers who are less financially sophisticated and who are dependent on a strategy that is yet untested by a
major market correction. In our view, this creates a recipe for poor investor decisions and wealth destruction
during the next period of extended market weakness.
ETF liquidity could create a sudden spike in volatility in a market panic, as seen in the August 2015
“flash crash.” While the 2015 flash crash was triggered by S&P futures trading, it led to widespread dislocation
between ETF prices and NAV. According to the SEC’s report on the flash crash, volatility was markedly higher
in ETFs/ETPs than the broader market, with 19% of ETPs declining 20% or more during the day versus 5% of
corporate securities.
7
The Death of Active Investing Is Greatly Exaggerated
“It was like shooting fish in a barrel.” That’s how Warren Buffett and Charlie Munger described value
investing when they first started out in the business. Someone making that claim today, however, would likely be
viewed as either a genius or delusional. With active managers losing assets to indexing and suffering from fee
compression (the average expense ratio of U.S. equity funds fell to 63 bps in 2016, down from 99 bps in 2000
according to the Investment Company Institute), today the investment management industry is the polar
opposite of shooting fish in a barrel, as the business has become far more institutionalized. Back when Buffett
was flipping through the
Moody’s Manual
and finding well-capitalized insurers trading at 2x earnings, less than
10% of U.S. trading volume was institutional. In short, prices were largely being set by retail investors decades
before the Internet was even conceived. Over the past 50 years, institutional trading has steadily gained share;
today it accounts for more than 95% of U.S. trading volume. Moreover, the quantity and quality of institutional
investors has increased markedly. During the past 5 decades, the number of investment management
professionals rose from 5,000 to over 1 million. Moreover, the number of CFAs went from zero to 135,000, the
number of Bloomberg terminals jumped from zero to 320,000, investment research exploded, and the Internet
and Regulation FD (fair disclosure) leveled the playing field.
8
Should it come as any surprise that active
managers are underperforming given that Mr. Market is much smarter today?
While the heightened level of competition seems to spell the death of active management (as the
investment management business is unlikely to become less competitive in the future), there is substantial hope
when one examines an equally important metric. Within a steady trend of rising competitiveness in the business,
there has been an equally consistent cyclical trend: the underperformance/outperformance of active
management.
7
Securities and Exchange Commission, Office of Analytics and Research, Division of Trading and Markets, “Research note:
Equity market volatility on August 24, 2015,” https://www.sec.gov/marketstructure/research/equity_market_volatility.pdf.
8
Charles D. Ellis, “The end of active investing?,”
Financial Times
, January 20, 2017, https://www.ft.com/content/6b2d5490-
d9bb-11e6-944b-e7eb37a6aa8e.
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