ETFs Don’t Always Imply Passive Investing

ETFs are all the rage in the investment business, recently passing $1 trillion in assets for the first time (see WSJ article), spurred on during the past couple of years as the only equity investment products to log significant inflows.

This is a remarkable ramp considering ETFs were first introduced in the mid-90s with the creation of SPDRs, the first of which tracks the S&P 500® and is still the largest ETF. But from this initial index fund – which was designed to give investors a low-cost, liquid vehicle to precisely track a large basket of stocks – ETFs now encompass a sprawling and constantly evolving list of products tracking everything from industry sectors to country performance to gold to long-term US Treasuries.

We believe ETFs have become so successful primarily because of a backlash against the high fees and mediocre performance of actively managed mutual funds. Unlike actively managed mutual funds, ETFs are:

1. Exchange traded, so you can trade them at any point within a trading day;
2. Almost exclusively passive (i.e., they track an index or market);
3. Inexpensive, because they are passive; and
4. Transparent, so you always know what you are buying.

It should be no surprise ETFs now represent a market a quarter the size of actively managed equity mutual funds, “Passive” advocates believe there is no appropriate role for actively managed mutual funds and use the ETF value proposition as their mantra. But let’s keep in mind ETFs are only passive when held for the long term, with the goal of matching the market.

We believe a majority of the new funds flowing into ETFs are actually being used to trade particular markets or instruments. Doing more with ETFs than simply parking money there for the long term requires allocation expertise, which is an active management skill few individual investors possess.

Our advice? If you want to generate active returns (or alpha) through the trading of ETFs, then hire professionals who have the proven skill/ability to allocate well.

One increasingly popular allocation strategy enabled by ETFs is tactical asset allocation. Tactical asset allocation rebalances the percentage of assets held in various categories in order to take advantage of market pricing anomalies or strong market sectors. Prior to the availability of ETFs, tactical asset allocators had to buy individual stocks to gain exposure to various market categories, which was cost prohibitive. Tactical asset allocators typically:

– Overweight asset classes most likely to outperform;
– Underweight asset classes most likely to underperform in the short term; and
– Measure their skill against a benchmark that usually consists of a mix of equity and Treasury indexes (for example, 60% S&P 500/40% Treasury).

This is in contrast to strategic asset allocation, which is a truly passive strategy. Strategic asset allocators create a long term asset allocation and rebalance if their asset classes fall out of line with their long term targets. While it is possible for an individual investor to execute a strategic asset allocation plan, it usually requires more time and attention than most individual investors are willing to spend.

If you truly want to take advantage of the power of ETFs, you should consider money managers who know how to capture the most value from them and have the track records to prove it.

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