July 15, 2019

Monday Morning Memo: Are you Making the Most of Passive Investing?

by Detlef Glow.

 

During the Refinitiv ETF Academy on July 3, 2019, Andrew Walsh, Executive Director, Head Passive & ETF Specialist Sales – U.K. & Ireland at UBS AM, gave a presentation called “Are you making the most of passive investing?” Since he gave a number of hints on how to research exchange-traded funds (ETFs), I thought it would be a good idea to revisit his points because the increasing number of ETF promoters and indices can lead to a steadily growing number of ETFs in the market. The increased competition, especially for “plain vanilla” products, has led to falling prices in this segment, while themes and strategy-based products—such as factor investing and environmental, social, and corporate governance/sustainable, responsible, and impact investing (ESG/SRI)—have a sufficient margin for their promoters.

Not only is the ETF segment is crowded, but index promoters also face a lot of competition from the more than 200 market participants offering indices. With the upcoming trend toward in-house indexation, the competition will increase even further, especially for strategies beyond plain vanilla ones. The increasing complexity of the markets has been noticed by a number of market participants and observers who have already raised their concerns. My personal view is that professional investors and advisors have to treat ETFs like other mutual funds: they need to do full due diligence on the respective indices to really understand the performance drivers of each index. Mr. Walsh showed in his presentation that selection of the right index can have more impact on the annual returns of a passive investor than the expense ratio of the best ETF covering the index. In this regard, it is key from my perspective that investors analyze the index’s methodology, since this defines the composition and, therefore, the performance of the index.

That said, Mr. Walsh stated that there is an ever-increasing awareness of the importance of looking under the bonnet of the underlying index which an ETF tracks. He pointed out that the key points to consider in selecting an ETF are:

  • A detailed view at the composition of the index, as just because an index has a similar name to another doesn’t mean they act the same.
  • In the same regard, it is important to understand the construction methodology of a given index.
  • This would also enable the investor to estimate the possible pitfalls of an index, as some indices have a high exposure to single securities, sectors, or countries.
  • Analyze the investability of an index, as the existence of an index does not mean that the underlying securities are investable or liquid.
  • Since index turnover leads to transaction costs within the respective ETF, an investor has to analyze the maintenance rules of the index and the resulting turnover.
  • A sound understanding of the performance pattern of the different “factors” can help to improve the risk-return profile of a portfolio.
  • Within the commodities segment, it is important to understand how the rolling of futures contracts are done and to analyze the variation in sector and component weights of the different indices.

Some Thoughts About Factor Strategies

I am using the example of factor strategies to showcase more details on one of the topics mentioned above. The market for factor strategies gets increasingly complex and Mr. Walsh pointed out that the methodologies of the different indices (even if they are offered by the same index promoter to exploit a given factor) can vary considerably. Therefore, it is essential for any investor who wants to buy a so-called smart beta or factor ETF to understand the rules for inclusion and/or exclusion, as well as the methodology for the weighting of the securities within the index.

From my point of view, one issue that arises from factor-based investing is that not all factors deliver outperformance all the time, and investors might need to rotate their factor exposure from one factor to another over time. Since timing is always one of the most difficult tasks in portfolio management, some investors will neglect to invest in factor strategies.

To serve the needs of investors with regard to timing of the use of single factors, some ETF promoters have developed so-called multi-factor ETFs that deliver a combination of factors as a one-stop shop solution for investors. With regard to these products, it is key that the investor understands how the single factors are weighted within the portfolio. Mr. Walsh made the point that investors who want to use these kinds of funds need to pay close attention to the index rules since they define how the portfolio is created and, therefore, how it will react to different market environments.

Summary

The European ETF industry has written a true growth story over the last 18 years, and the assets under management, as well as the number of products available for investors, are steadily increasing. The increasing number of indices tracked by ETFs offer many opportunities for investors, but these opportunities come with the price of higher market and product complexity. From my point of view, it has become essential for investors to introduce proper due diligence if they want to select the ETFs that really suit their needs and deliver the returns they are expecting. In other words, investors need to select ETFs in the same manner that actively managed portfolios do in order to make the most of their passive investments.

The views expressed are the views of the author, not necessarily those of Refinitiv.

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