EX­CHANGE-TRADED FUNDS

Al­go­rithms and fil­ters that mimic what a man­ager would do have blurred the lines

Financial Mail - Investors Monthly - - Contents -

Eq­uity in­vestors will be heav­ing a sigh of re­lief af­ter the fourth quar­ter kicked off on a pos­i­tive note for mar­kets, spurred by the US Fed’s con­tin­ued hem­ming and haw­ing about in­ter­est rates.

That’s af­ter a pretty dis­mal third quar­ter that left the JSE 3,3% weaker, tak­ing losses from its April 24 high to 7,8%.

De­spite a ten­ta­tive re­cov­ery in early Oc­to­ber, the de­bate about ac­tive ver­sus pas­sive in­vest­ment has been reignited.

The pro­po­nents of an ac­tive in­vest­ment ap­proach are stick­ing to their guns.

They ar­gue that you need some­one to look out for you in mar­kets like th­ese — some­one who can se­lect the in­di­vid­ual stocks for you that will pro­tect you against the volatil­ity and down­ward pres­sure.

Af­ter all, the pro­po­nents ar­gue, if you buy the mar­ket, you fol­low the mar­ket, whether it’s go­ing up or down.

But it’s not that clear-cut any­more, with some steep moves in in­di­vid­ual sec­tors.

So while hold­ers of a Top 40 in­dex would have moved mostly side­ways over the past year, hold­ers of resources ETFs are likely lick­ing their wounds. A short squeeze in late Septem­ber made the Resi 10 bounce 16% in the space of a fort­night.

So, for those who had taken an ac­tive de­ci­sion to buy an ETF fo­cused on the resources sec­tor — per­haps ro­tat­ing out of fi­nan­cials or in­dus­tri­als — there were big re­wards on of­fer.

Sim­i­larly, the ad­vent of smart beta ETFs has put a more ac­tive ap­proach into pas­sive in­vest­ing. Smart beta refers to in­dices that the clever folks at S&P Dow Jones, the FTSE/JSE and the likes have con­cocted us­ing all sorts of fancy al­go­rithms.

Lance Solms, a di­rec­tor at ETF in­vest­ment plat­form Itrans­act, doesn’t like the pas­sive la­bel ap­plied to ETFs be­cause it sounds as if no­body does any­thing. Solms ar­gues that any in­vest­ment de­ci­sion has an ac­tive el­e­ment to it, which he prefers to call “in­dex in­vest­ing”.

Of course, Solms doesn’t rule out ac­tive in­vest­ing, be­cause in­vestors need to use as many levers as pos­si­ble to max­i­mize re­turns for them.

Which brings me back to the is­sue of smart beta.

Th­ese in­stru­ments have var­i­ous fil­ters that fine-tune the un­der­ly­ing in­dices to ma­nip­u­late the out­comes.

Smart beta ETFs that have done par­tic­u­larly well over the past year in­clude the Core­shares S&P SA Low Volatil­ity ETF (LowVoltrax) and Absa’s NewFunds Eq­uity Mo­men­tum To­tal Re­turn ETF. In fact, they’ve not only done a lot bet­ter than the FTSE/JSE Top40 To­tal Re­turn in­dex, they’ve beaten ac­tively man­aged unit trusts too.

It works like this: the LowVoltrax uses a fil­ter to se­lect the 40 least volatile stocks of the past year, which in­clude the likes of the re­tail­ers but at this stage would ex­clude choppy stocks in the resources sec­tor.

Equally, the Eq­uity Mo­men­tum se­lects those that have been show­ing the strong­est price mo­men­tum. It’s al­most me­chan­i­cal as­set man­age­ment, us­ing an ap­proach that is both un­emo­tional and quan­ti­ta­tive.

That’s all very well when mo­men­tum is to the up­side, says Nic Nor­man-Smith from Len­tus As­set Man­age­ment. How­ever, when those mo­men­tum stocks which have been pushed well above their fun­da­men­tal val­u­a­tions run out of steam and start fall­ing, the ETFs that have done well on the back of them won’t fare as well, he says.

This, of course, is when the value of ac­tive man­age­ment shines through.

Still, LowVoltrax has man­aged to hold its own dur­ing the re­cent pe­riod of volatil­ity, over­tak­ing NewFunds Eq­uity Mo­men­tum in terms of per­for­mance mid-year as the mo­men­tum wore thin.

What all this il­lus­trates is that the lines be­tween ac­tive and pas­sive are in­creas­ingly be­com­ing blurred thanks to the al­go­rithms and fil­ters that mimic what an ac­tive man­ager would do.

And while Solms says there are mer­its to both, Nor­man-Smith agrees that it’s a cheap way for in­vestors to get ex­po­sure to a spe­cific sec­tor of the mar­ket with­out tak­ing a sin­gle-stock risk.

Though he’s a long-only in­vestor, Nor­man-Smith says that some man­agers could short a re­source ETF if they felt bear­ish about the sec­tor and wanted to take a hedge.

Equally im­por­tantly, as the lines be­tween pas­sive and ac­tive in­vest­ments are be­com­ing blurred, so are the costs.

Don’t ex­pect to pay the same ul­tra-low fees for smart beta ETFs as you do for the vanilla in­dex track­ers.

In some cases, the fees are pretty close to what you pay for ac­tive funds.

How­ever, while the bull run may have a lit­tle fur­ther to go, and your vanilla ETFs will con­tinue to en­joy the up­ward mo­men­tum, ac­tive man­age­ment can pro­tect you from a down­turn.

❛❛ Af­ter all, the pro­po­nents ar­gue, if you buy the mar­ket, you fol­low the mar­ket, whether it’s go­ing up or down

STEPHEN GUN­NION fol­low Stephen on Twit­ter @stephen­gun­nion

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