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The exponential growth of passive investment vehicles over the past ten years has been astonishing since the infancy of index investing that Vanguard made so famous back in the early 1980s.  In the first part of this discussion, I spoke at length about the need to really read the prospectus or fact sheet of an Exchange Traded Fund (ETF) or an index mutual fund.  Two similarly sounding investments may actually have quite different underlying components.  I utilized two different emerging market stock ETFs to demonstrate the difference, and they were the iShares MSCI Emerging Markets Stock ETF (Ticker Symbol:  EEM) and the Vanguard FTSE Emerging Markets Stock ETF (Ticker Symbol:  VWO), respectively to show why this is true.  The main issue in this case was that one considers South Korea to be a developing economy (EEM), and the other (VWO) does not.  Therefore, a large component of your investment allocation in your portfolio to emerging market stocks may be more heavily weighted toward South Korea than you at first thought (over 15% in fact).  For the details of the discussion, you can click on this link:

https://latticeworkwealth.com/2014/01/28/not-all-index-mutual-funds-and-etfs-are-created-equal-part-1-of-2/

The second issue that I hinted at in part 1 relates to the definition of passive investing.  The active management versus passive investing debate has been raging on for over 30 years with proponents on both sides of the fence.  In its most general form, passive investing is choosing to invest in all stocks or bonds tied to a particular index, such as the S&P 500 Index, Russell 2000 Index, MSCI EAFE Index, or the Barclays Aggregate Bond Index.  The investor in this case decides that he/she would rather participate in the investment performance of all the components of the index rather than picking the best stocks or bonds themselves.  Active managers strive to beat the investment performance of a particular index by scouring the quantitative and qualitative data about each particular stock or bond.  These professionals believe that they have the ability to make superior investment choices and do better than average (i.e.  just settling for the investment returns of the index less the expenses of the ETF or index mutual fund).  I spoke at length about active and passive investing in one of my earliest blog posts.  Here is the link to that more involved discussion to get further detail:

https://latticeworkwealth.com/2013/07/05/difference-between-active-and-passive-investing/

A new type of investment vehicle has sprung up during the development of the ETF industry, and it is referred to as “enhanced indexing”.  The idea is that you can approach the debate by using a hybrid view of sorts.  Enhanced indexing is investing in a particular index but not investing in all the stocks or bonds or choosing to weight the stocks or bonds differently than the index does.  These ETFs offer the ability to use the asset manager’s proprietary strategy to pick the “best” members in the index.  There are many managers that do this, and two of the most popular are offered by the WisdomTree company and Dimensional Fund Advisors.  The ETF and mutual funds offered by these companies follow a similar philosophy with different approaches.  However, each company strives to outperform the index that their portfolio managers select.

There is nothing wrong with any of the offering of these companies.  In fact, many of their investment vehicles have had superb performance over the years.  This salient point is that they are really “blurring” the line between active and passive investment philosophies.  Using a more strict definition of passive investing, the investor knows at the outset that they will underperform the index by the amount of fees (and “tracking error” – a concept I will not go into specifically in this post) assessed to the ETF or index mutual fund.  However, they will not significantly underperform because all the components of the index are always held.  An active investment vehicle has the ability to outperform or underperform an index after fees are assessed each year.  Investors in enhanced indexed ETFs or mutual funds fall into the latter category.  Once the asset manager makes a decision to pick the “best” components of a particular index, they are moving into the realm of active management.  One of the appeals of this investing strategy to individual investors is that you can still beat the index.  With that being said though, you are taking the chance that the investment will underperform what the passive ETF or index mutual fund delivers in terms of investment returns.

Enhanced indexing may seem like a great way to “have your cake and eat it too”, but, at its core, active management (either by way of a proprietary computer algorithm, back tested studies, qualitative metrics, or some other method) nonetheless.  Many individual investors fail to recognize that they are really choosing an active strategy, although some professionals would argue that it is more sophisticated than the approach of traditional active managers.  As long as you are aware of this fact at the beginning, there is nothing wrong with that.  In fact, many investment advisors use a combination of active and passive investment vehicles when building a portfolio for their clients.  For example, it has been shown that there may still be inefficiencies in micro cap (normally stocks with a market capitalization below $1 billion) stocks because very few Wall Street analysts follow the companies and provide investment recommendations.  On the other hand, there are a plethora of Wall Street analysts who follow the largest companies in the US, so it becomes much harder to know more than other investors.  Thus, some financial professionals will advise a certain portfolio allocation to passive ETFs and another piece of the portfolio will go to active managers.  This type of approach is a hybrid approach.

In the case of enhanced indexing (or “smart beta” funds – similar type of concept that I will not elaborate more on in this discussion), the individual investor is allowing the asset manager to make active selections which is much more akin to active investing.  The key is to know that you run the risk of two things.  First, the particular investment vehicle may do worse than the corollary strictly passive ETF or index mutual fund in terms of investment returns.  Second, the asset manager may not always be fully invested in the index at all times as well.  Therefore, you may have a higher allocation to cash than you initially wanted.  Now if the asset manager sells stocks to raise cash before a downturn in stock prices, the individual investor will not lose as much as other market participants.  The flipside is that the individual investor fails to participate fully in any stock market rally.  This second part is emphasizing that the asset manager may lag the investment performance of the benchmark index even more so than the passive ETF or index mutual fund.

The important thing is to simply know up front that passive investing involves average underperformance at the outset.  However, you are assured of at least capturing the lion’s share of the investment returns.  Any other investment vehicle may do better or worse over the long term which is the main concern of an individual investor.  If the enhanced indexing investment strategy yields lower long-term investment returns for your portfolio, you have paid money to “lose” money on a relative basis.  What I mean by this is that, as an individual investor, you could have just invested in the entire index of stocks or bonds at a very low cost by doing absolutely nothing.  If the enhanced index manager outperforms the index after fees are taken into account, that investment decision was a wise one.  However, history has shown that active managers tend to lag their proper benchmark over the long term (usually defined as 5 years or more).

It may be enticing to try to combine the best features of the passive investing and active investing philosophies.  With that being said, individual investors need to realize that any departure from the strict definition of passive investing increases the odds that the manager will have an investment return different than the index.  If your investing time horizon is 5, 10, 15, 20 years or more, the active mangers (either in its pure form or via enhanced indexing) has a more difficult time outperforming the index year in and year out to provide the individual investor with performance above and beyond what the “stodgy”, old passive ETFs or index mutual funds offer.  I would characterize this more as “buyer beware”.  The main takeaway is not that these are “bad” investments at all; rather, it is a conscious choice to depart from the passive world of investing and move to the active side.

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