Are changes in investor preferences hurting returns?
Innovation in the financial services industry is providing us with more choice...but at what cost?
I was recently at the Morningstar Investment Conference. One of the speakers was talking about actively managed ETFs. I will keep his name and firm to myself. But he was making the argument that actively managed ETFs were the next big thing in Australia. He believed Australian investors loved actively managed products.
This got me thinking. Do Australians love actively managed ETFs? And if we do, what are the implications?
Active vs passive
Since the advent of passively managed funds and ETFs there have been critics. Unsurprisingly many of these critics are incentivised to back active management.
When Vanguard launched the first index fund for individuals in the mid-1970s an investment research firm called The Leuthold Group actively encouraged their clients to help rid the world of this menace. Their slogan for the campaign was McCarthyesque. “Help stamp out index funds! Index funds are un-American.” They weren’t stamped out.
Asset Manager Sanford C. Berstein published a 47-page report in 2016 titled “The silent road to serfdom: Why passive investment is worse than Marxism.” You can’t accuse them of burying the lead with that title.
Change is hard. And the people that are negatively impacted by change are much more vocal in their opposition than the beneficiaries of the change. For close to 50 years the opponents of passive investing have been the loudest. And while the examples I included are extreme they do demonstrate the level of discourse about passive investing in the industry. If all else fails, yell louder.
In opposition was Jack Bogle. The figurehead of passive investing didn’t need to be sensationalist. He had the facts on his side. And those facts play out every six months when Morningstar release the Active / Passive Barometer report. Most active managers fail to beat their benchmark over the long-term.
The following chart is from the Morningstar US Active / Passive Barometer Report using data from 31 December 2023. It illustrates the struggles that active managers have beating their index.
Can anyone beat the market over the long-term?
I believe the answer is yes. I think there are certain professional investors across a disparate set of strategies that can generate market beating returns over the long-term.
Perhaps more relevant to the audience reading this article I believe that everyday investors can beat the market. In fact, given the structural impediments placed on most professionals I think it is easier for an everyday investor to outperform over the long-term. More on this later.
You might imagine that my proclamation that professional investors can outperform means my portfolio is full of actively managed funds and ETFs. Nope. Not a single actively managed fund or ETF is my portfolio. Why the disconnect?
While I think that there are professionals that can outperform I think many of them are out of my reach. Working as a portfolio manager is not a charitable activity. And while not everyone in the industry is primarily motivated by money many of the star investors tend to navigate to places where the profit potential is larger and / or the annoying constraints are less.
The fee structures of hedge funds are much more lucrative than a managed fund or ETF. And the constraints are less. There are also less constraints on insitutional managers like endowment managers and large industry super funds. One issue that actively managed retail fund and ETF managers must contend with is the poor tendencies of investors. Even short periods of underperformance cause retail investors to switch to new products.
And this impacts fund manager behaviour in ways that make it harder to outperform over the long-term. A focus on the short-term means shorter holding periods and more trading. Which means more taxes for me to go along with poor performance.
It means these professional managers are constantly searching for a catalyst. That is hard. It means closet indexing. It means having to deal with more money to invest when things are going well and good opportunities are harder to find. It means having to sell when markets are down and there are more opportunities.
Groucho Marx once said that he would never join any club that would have him as a member. And that neatly sums up my attitude to actively managed retail products. There are good ones out there but I can't be bothered to search for them. I'm happy to spend my time finding individual shares which I combine with factor and index ETFs.
It also shows the folly of people who take their cues from the professionals who behave poorly. Those are the people that search for short-term catalysts and constantly trade. Those are the people that ignore tax ramifications and invest when markets are high and sell when markets are low. I spend more of my time trying not to be one of those people than searching for investments.
Is Australia different than the US?
The argument made by the speaker at our conference is that Australian investors want actively managed ETFs. There are portions of the data that support this view but when taken holistically I struggle to come to the same conclusion.
Active ETFs are growing quickly in the US. Morningstar data has shown that much of the shift into actively managed ETFs is from actively managed mutual funds which is the US nomenclature for managed funds. So yes, I do think that US investors prefer actively managed ETFs to funds. I see no reason why Australians would be any different.
However, Morningstar data also shows the total amount of money invested in passive products surpassed active products in the US in late 2023. This was the inevitable result of years of more money flowing into passive investments. The following chart shows the market share changes for active and passive funds for the last 30 years.
Australia is behind the curve in both the transition to ETFs and the transition to passive. According to the Investment Company Institute 24% of all assets managed by investment companies in the US were in ETFs at the end of 2023.
I couldn’t find corresponding data for ETFs in Australia but there are $153 billion of assets under management in ETFs in late 2023 according to Betashares. This makes up only 4% of total superannuation assets. And there are countless assets outside of super.
Self-managed super funds where a trustee has discretion for choosing investments have a slightly higher allocation to ETFs with approximately 5% of overall assets. The trend is clearly tilting locally in the same direction as the US. Younger investors are increasingly gravitating towards ETFs and more advisers are using the vehicle. There is just a long way to go.
Passive shows similar trends but is also trailing the US. According to Rainmaker around 20% of all Australian assets are invested passively in mid-2023.
There are structural reasons in Australia which makes it hard to envision the adoption of passive or ETFs will be as widespread as the US. Unless we see widespread use in retail and industry super the percentage of total assets is limited well below US levels. However, the trend is clearly favouring both passive and ETFs. More everyday investors and financial advisers are picking this style and vehicle within their portfolios. I suspect that much like the US passive will dominate the ETF space in Australia.
Is any of this good for investors?
Yes and no. Passive investing is a definitive win for investors. We get access to low-cost passive investments that outperform most active managers. And the rise of passive has lowered the fees for active managers who are desperately trying to compete. This was demonstrated again this week as Macquarie lowered the fees on some of their actively managed ETFs to .03%.
I’m less confident that the shift to ETFs from managed funds is a win. ETFs certainly have some advantages over managed funds in the eyes of investors. The main one is that they are significantly easier to access. And to be fair this is why I invest in ETFs. The problem is that these lower barriers to trading have made it significantly easier for us to behave badly.
The interesting thing about investing is that how we behave has a much larger influence on the returns we earn than how smart we are or how much we know about investments. That means that structural impediments to bad behaviour can improve returns more than ‘better’ investments can.
Vanguard legend and passive investing cheerleader John Bogle didn’t like ETFs. He thought that the ability to trade frequently would lead investors to do just that. And he thought that would hurt returns. There is evidence to suggest he was right.
A study conducted by UTS explored whether individual investors benefit from the use of ETFs. The study found that portfolio performance when investors used ETFs was lower than when they didn’t.
It wasn’t a small loss. The study found that ETF portfolios underperformed non-ETF portfolios by 2.3% a year. The loss is the result of buying ETFs at the wrong time rather than choosing the wrong ETFs.
A critical finding in the study was that ETF portfolios did actually outperform if the investor bought the investment and held it for the long-term.
I fear that further adoption of active ETFs at the expense of actively managed funds will make this problem worse. Investors exhibit poor behaviour when they invest with passive products. They tend to jump from passive investment to passive investment based on performance. Ironically many people use passive investments but aren't investing passively. Even more ironically many of them will cite the advantages of passive while taking actions that negate those advantages.
I think the problem will get worse with active ETFs. Investors will likely exhibit the same behaviour among investment categories. They will jump from US shares to Japanese shares to emerging market shares based on short-term performance. But now they will also jump between different active ETFs within the same category by exchanging one Japanese share ETF for another based on relative performance.
Final thoughts
A lot of energy has been expended by the industry on the active vs. passive debate. Much of the debate is self-motivated. None of it has stopped the passive steamroller.
And in the retail investing community there has been a lot of cheerleading for ETFs in the mistaken view that the wrapper is the investment and not the group of stocks or bonds in it. This is consistent with how people make decisions. We don't decide between things. We describe between descriptions of things. Think about that the next time you read the description of an ETF.
I’m fairly perplexed by all of it. The data is clear. Most active managers that retail investors can access can’t outperform the index. The choice between passive ETFs and the corresponding fund is largely irrelevant in any meaningful way other than ease of access. But these are the things we talk about and argue about.
Investors can’t see the forest for the trees. It isn’t the types of investments in our portfolios that are holding us back. It is us. Want to beat the market? Change the way you invest. Worry less about the investments.