Passive aggressive and other ETFs
The definition of an exchange traded fund (ETF) is innocent and broad. Simply put, an ETF is a type of investment fund that is traded on a stock exchange. I guess the clue is in the name. It’s an important distinction, though, as unit trusts are not traded on exchanges.
Passive ETFs can be traced back to 1993, when investment firm State Street launched the SPDR (“Spider”) S&P 500 ETF in the US. A passive ETF tracks an index and gives investors a way to obtain broad market exposure with a single, low-cost investment. This is critical in any wealth-creation strategy, as even the most seasoned stock pickers use ETFs to introduce “beta” (the market return) into a portfolio. They strive for “alpha” (outperformance of the market) on top of this.
According to data-gathering company Statista, the number of ETFs in existence rose from 273 in 2003 to 8,552 in 2021. Notably, the number of ETFs increased by 15% in 2021, so there is still plenty of interest in this space.
By now, you must be wondering why the world needs this many passive funds that track indices. Aside from regional funds to address regulatory requirements (for example S&P 500 ETFs listed on the JSE to enable uncapped access to the broad US market for South Africans), the truth is that the world doesn’t need that many passive funds. But within the world of ETFs things aren’t so passive any more.
Investment bank Bear Stearns launched the first actively managed ETF in 2008 — the Current Yield ETF. Bear Stearns failed in the global financial crisis, so this was its parting gift to the world. Online ETF databases suggest that there are about 850 actively managed ETFs trading on US markets today.
These provide exposure not just to equity, but also to fixed income, commodities, currencies and other asset classes. With assets under management (AUM) of more than $19bn, the JPMorgan Ultra-Short Income ETF is the largest in the market.
The market cap of ARK Innovation ETF (Cathie Wood’s flagship product) is $12bn, putting it in the top four by AUM and ensuring that Wood still has more than enough income to pay her analysts to churn out white papers and commentary about how tech has miraculously become “deep value”
a comment that nearly gave every Buffett zealot a stomach ulcer.
Things get interesting and more innovative (sorry, Cathie) as you move further down the AUM list.
For example, the VanEck Video Gaming & eSports ETF ($ESPO) holds a portfolio of stocks related to video gaming and e-sports, as the name indicates. Rather than trying to pick the winners in this space, you can form a view that gaming is a growing market and invest in it accordingly. The AUM for $ESPO is about $435m. This is a core long-term holding in my portfolio.
To demonstrate how esoteric this world can become, there’s an ETF called the FIS Biblically Responsible Risk Managed ETF, which trades under the clever ticker $PRAY. The ETF seeks to invest in companies “whose business practices align with Christian values” using a quantitative screen and then a “Christian overlay filter” that eliminates companies engaging in the likes of gambling and alcohol. The top holdings are Palo Alto Networks and Apple, with Nvidia also in the top five. Yet I wouldn’t have thought that Apple is a leading example of doing unto others as you would have them do unto you.
This is the danger with active ETFs — they can become a tool to slap a marketing label on a product that becomes harder to justify the more you dig. The world of environmental, social and governance (ESG)-based investing is more guilty than anyone when it comes to this. Rules-based filters don’t pass the common-sense test, like British American Tobacco being a top-rated ESG choice.
Still, don’t make the mistake of ignoring actively managed ETFs just because of questionable examples. They are powerful tools for thematic investing. For example, $SOXX is a semiconductor ETF that holds all the major chip companies except for Taiwan Semiconductor Company (TSMC), the largest and most geopolitically sensitive company in the sector.
Top holdings are Broadcom, AMD, Qualcomm, Nvidia and Intel. I don’t know enough to make an informed assessment of the technology of each company to try to pick a winner. But I do believe that supply chains are localising and that the US needs to reduce reliance on TSMC (confirmed by results commentary from companies like Ford), so I’ve added $SOXX to my portfolio.
As the famous term goes: “There’s an ETF for that!”