The rise of active management in a passive world: Editor's Note
Just because it says ETF on the tin doesn't mean the fund operates in the tradition of Buffett or Bogle.
After 20 months of being "always-on", my colleague advised me to switch off from work during a recent mini-break. Leave the laptop at home, don't look at emails, turn off notifications. I took that advice, for the most part, except for cracking open Robin Wigglesworth’s Trillions over frozen margaritas.
The new book chronicles how an unlikely band of Wall Street renegades invented the index fund and changed the course of finance. In the first chapter, Wigglesworth details how index funds developed alongside frustration with high fees charged by hedge funds, many of whom could not demonstrate consistent long-term outperformance. The early thinkers were united by the radical idea that if investment funds struggled to outperform the broader market after adding in trading and operational costs, why not just buy the market? So deep was this belief that the world's most famous investor Warren Buffett bet his reputation (and $1 million dollars) on the conviction that an S&P 500 index fund that merely tries to mimic an index could beat a portfolio of hedge funds. A decade later, Buffett won that bet, handily, striking a symbolic victory for index funds as an acceptable form of investment management.
From the first humble index fund a $26 trillion mega-industry, passive investing has changed the course of financial markets as money moves away from active management and into the hands of the "new captains of capital": Vanguard, State Street, and Blackrock.
“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients,” the Financial Times' global finance correspondent wrote quoting Buffet. “Both large and small investors should stick with low-cost index funds.”
As I flick through the initial chapters, I’m struck by how index funds have become almost synonymous with exchange-traded funds for individual investors. But the resemblance between the ETF industry of today and the beautiful simplicity of the first index fund is fading. First developed in the 1990s, ETFs were an extension of the index fund, introduced to bring passive investing to the masses. They took low-cost, index-tracking funds and democratised access via the exchange. And sure enough, when ETFs first came to Australia, the initial batch of products were vanilla, market-cap weighted, index-tracking funds like the SPDR S&P ASX 200 ETF and the Vanguard US Total Market Shares Index ETF. This created an enduring association between the strategy of investing passively and the act of holding ETFs. But today's ETF landscape has shifted in two important ways.
The universe of available indexes has exploded, allowing ETFs to track anything from the space race to stocks hyped on social media. Today, ETF investors can buy increasingly niche slices of the market, taking tactical bets on sectors and trends (rather than trading individual securities). But the larger innovation has come with actively managed ETFs. Brought to life locally by Magellan Financial Group in 2015, one of the few active managers with a big profile among self-directed investors, active ETFs are listed funds managed by a portfolio manager with the aim of outperforming the market. They don't track an index, nor are they dirt cheap. Some have avoided being fully transparent about their holdings thanks to a deal struck with the regulators. Active ETFs are a good reminder that ETFs are merely a wrapper. The name does not speak to the management style of the product—merely that's it's listed on the exchange. The clue is in the name: 'exchange-traded fund'.
The reasons active managers are seeking to list their strategies on the exchange are simple: ETFs bypass investment platforms and intermediaries, giving non-advised investors direct access to their products without high minimums or paperwork; they're simple to buy and sell; and they tap into the popularity of the listed format among first-time investors. 2021 represents the biggest year for active ETF launches in Australia with around 15 new funds coming to market. That's more than passive ETF and strategic beta ETF launches combined. While the vast majority of assets remain with conventional, mainstream passive ETFs, there's no doubt the investment management industry and the exchanges see actively managed listed products as a major area of growth.
MORE ON THIS TOPIC: Beat the market: should you buy active ETFs, LICs or unlisted managed funds?
There's nothing inherently wrong with active ETFs, or the people selling them, as long as investors know what they're buying. But in my view, active ETFs are beneficiaries of the good reputation index-funds and passive ETFs have built over decades by association. The takeaway for investors is just because it says ETF on the tin doesn't mean the fund operates in the tradition of Buffett or Bogle. Index funds passively track indexes, but ETFs may not. Take a critical eye to products – how they're invested, what they're charging and how they've performed. The index fund industry started as a radical idea among a small group of academics that investors would be better off buying funds that track the market. Today, the picture is much blurrier.
As Wigglesworth writes:
"Whatever your investment palate, there is now a flavour of ETF to tickle it. That may be true, but the downsides are real: The evolution and proliferation of ETFs are giving investors the ability to commit the same original sin that many of the inventors of index funds hoped to cure."
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