Financial Mail - Investors Monthly
EXCHANGE-TRADED FUNDS
Algorithms and filters that mimic what a manager would do have blurred the lines
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