In a world of ETFs, what’s next for active managers

The investment industry is changing and at a record pace as investors are jumping on the passive bandwagon headfirst. One can’t blame them given the ultra-low fees that accompany most exchange traded funds (ETFs) combined with the difficulty in most active funds to deliver superior returns in this bull market environment.

Take for example the S&P 500. The research we’ve read shows that the top seven contributors to the S&P 500’s returns over the past five years are all technology stocks, which have been responsible for more than 60 per cent of the index’s total returns. Therefore, active managers who didn’t own these stocks in their funds, especially those who are value focused, would have underperformed. Throw in higher fees and this performance gap widens even further.

Some argue that this is the beginning of the end for active management, which is something we disagree with. Rather, when you get down to the basics, both are product manufacturers aggressively competing for shelf space among brokers and advisers who have become important distribution channels. Consequently, we think that the fees for active management will eventually fall to a level similar to ETFs, with those who have strategies that cannot be easily replicated by ETFs maintaining premium pricing. This also means that size and scale is paramount to compete in this space with the smaller investment managers getting squeezed out of the market.

However, the rapid growth in the number of ETFs being incubated — in total there are now over 5,300 ETFs globally — combined with low-cost funds across multiple strategies means investors will still need help in portfolio design and allocation. As an OCIO (outsourced chief investment officer) we are big proponents of taking a diversified approach including both passive and active, alternative and risk-managed.

While the fee structures for all of these are falling, unfortunately there is a trend by advisers and brokers to focus on the cheapest ETFs in order to preserve their own profit margins. While fees are important they shouldn’t drive the investment decision making process and at times can prove to be outright dangerous.

A great example of this is in the high-yield fixed-income space, which has been quite popular among advisers given the low interest rate environment. There could, however, be a serious problem lurking in the underlying assets held by the ETFs, as many have been forced to pay a large premium for lower quality, illiquid bonds.

What happens when there is a material sell-off in this sector and these bonds suddenly go no bid? Does this mean the higher quality, more liquid bonds are sold first in order to meet the instant redemptions required by their open market structure? Or could these ETFs suddenly go no bid themselves resulting in a large drop below their net asset value? Either way it could get quite ugly.

Compare this to perhaps a slightly higher fee, active high yield bond manager who only holds more liquid, higher quality positions with an investor base perhaps not as eager to hit that sell button during periods of market turmoil.

This isn’t to say that ETFs shouldn’t be used, but we think it’s the advisors job to thoroughly research and understand their respective strategy and if the liquidity of the underlying assets are sufficient for the size of the ETF. If not, then perhaps there are active funds out there that can mitigate these risks which is worth paying a premium for.

This is one of many factors an investment professional can help with. The key is that this person is one that acts independently meaning they are removed from the sales process and therefore not considered part of any “distribution channel.” Finally, while fees are an important consideration, the bottom line should be the creation of a well-diversified portfolio that is managed for risk alongside one’s target returns.

Martin Pelletier, CFA is a Portfolio Manager and OCIO at TriVest Wealth Counsel Ltd, a Calgary-based private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.