ETFs let advisors do their jobs

It’s a known fact that over the long term very few active investment products have been able to outperform their benchmarks. Don’t believe me? Here are some stats from the SPIVA (Standard & Poor’s Indices Versus Active Funds) report.

The report found, for year-end 2009, five-year period, only 7.4% of actively managed Canadian Equity funds have outperformed the S&P/TSX Composite Index. In the U.S. equity category, 9.2% beat the S&P 500. International managers did slightly better, with 10% outpacing the S&P EPAC LargeMidCap.

It’s primarily for this reason that broad-based ETFs have become popular. Though this may cause some to worry, the upside of this is that ETFs allow advisors to focus on financial planning and do the most important part of their job: asset allocation. Since 80% of a portfolio’s net return is derived from the asset mix, this really is where the heavy lifting is done.

The broad-based exposure and low cost of most passive ETFs make them ideal building blocks for a portfolio. And advisors who use them don’t have to worry as much about stock picking and market timing, because ETFs can offer the diversification needed to harvest beta – the bulk of a portfolio’s long-term return.

According to John De Goey, vice-president, Burgeonvest Securities Limited, this is the direction advisory services should be moving in. Eventually, he says, the role of the financial advisor will no longer be associated with order taking or a brokerage. With advisors now oriented toward financial planning, their value proposition has changed – it’s no longer about picking stellar stocks.

“The most value an advisor adds doesn’t come in the form of stock picking, sector rotating or market timing. The advisor’s true value proposition lies in helping clients maximize their long-term, client-specific, risk-adjusted, after-tax and after-cost returns,” he says.

Before deciding which investments to buy, the first and most important step an investor should take is evaluating risk profiles and thinking about what the portfolios should look like from an asset-allocation perspective, says Som Seif, president and CEO, Claymore Investments.

“It’s not a question of, ‘Do I invest in ETFs or mutual funds or stocks?’ It’s a question of, ‘What’s my risk perspective? How much money do I put into equities? How much money do I put into bonds?’ Things like that [have] more of an impact on overall net return portfolio than any other decision about, ‘Do I pick this money manager, this ETF, or this stock that beat the market over time?’ ” says Seif.

Doug Macdonald, RFP, Vancouver-based Macdonald Shymko & Co. Ltd., says broad-based ETFs provide a better proxy of the market than active funds. The precise exposure and transparency offered by these types of ETFs make them better building blocks for asset allocation, allowing his team to do a better job for clients.

“When you’re investing in an active manager, the manager may say he’s a U.S. medium-to-small- cap investor, and you put him in your portfolio in that category, and next thing you know, he’s out there in large cap.”

After heavy lifting comes the fine-tuning

Beta is plentiful and inexpensive, says Heather Pelant, managing director, and head of iShares at BlackRock Asset Management Canada Limited.

In terms of investment products, broad-based ETFs, such as those offered by iShares, are the most cost-efficient sources of beta, so it makes sense to seek them out in building the core holding of a portfolio.

Investors who want some out-performance in their portfolios can hunt for authentic active funds to generate some alpha, says Pelant, but with one caveat: “If you can find good active managers who add value over time, grab them and hang on to them because they’re rare.”

Tom Bradley, president of Steadyhand Investments Inc., says as far as performance goes, a very simple ETF-based portfolio is a good place to start. Before a client sets up a portfolio that has some variety of active management, he suggests a four-pronged ETF portfolio, with each ETF covering a core asset class: bonds – Canada, U.S. and International. Anything built from there should add value in terms of higher returns, or a different pattern of return.

With this approach, Bradley says investors should be wary of two types of ETFs. The first: sector-specific ETFs – a challenge even for seasoned advisors. The second: closet index products that charge active management fees but closely track their index. Bradley takes issue with sector-specific ETFs, such as healthcare and agricultural funds, that make investors think they can make sector bets, which is not only risky, but also the toughest approach to generating alpha.

Bradley adds that a top-down asset allocation – and certainly sector rotation – is a tough way to generate alpha. “I think of the quality of alpha and the potential for alpha and that is the lowest quality in the sense that it’s the toughest to do,” he says. “It’s more reliable to generate alpha with a bottom-up security selection, as opposed to top-down asset allocation. I think it’s scary the way the industry is trying to turn people into sector rotators. “The ads make it all glorious, but that’s not where we want to be going with 99% of individual investors.”

Also, investors who already have broad-based and low-cost ETFs in their portfolios should avoid closet index funds. Bradley says there are many active funds that really behave as index funds but charge active management fees. And these products do not complement passive, broad-based ETFs.

In 2006, Yale School of Business professors Martijn Cremers and Antti Petajisto published their paper: “How Active is Your Fund Manager?” They studied 2,650 U.S. mutual funds between 1990 and 2003 and found only half of self-described active funds were truly active.

They found that the most truly active funds outperformed their indexes after expenses by 1.49% to 1.59% per year; the least active funds underperformed by -1.41% to -1.76% per year. Truly active managers with up to 60% to 80% of portfolio holdings that deviated from the index tended to outperform the index. What’s more, their performance records were persistent – if they beat the market during three consecutive years, they were likely to repeat the pattern in the following three years.

Finding alpha in inefficient markets

The ongoing debate between active versus passive management is based on the argument of market efficiency. Active managers say value can be found in inefficient markets because there’s information asymmetry that leads to stock mispricing. By contrast, in efficient markets all information is already reflected in the stock market, so it’s virtually impossible to outperform in the long term.

These managers go on to argue that indexing in efficient markets makes sense from a performance and cost perspective; if you can’t beat it, you might as well match it. But in an inefficient market, individual stock selection may provide more value.

Some would say the U.S.-based large companies are among the most efficient in the market. These companies are studied to death; witness the 30-plus analysts (as of 2008) on Wall Street who followed Intel. Compare that to the three who research small-cap Avista Corporation (a northwest utility company).

Emerging market and small- company sectors are among the least efficient because there’s less information about the companies for traders to act on. This leads to a wider magnitude of mispricing and creates opportunities for active managers to exploit those mispriced stocks.

Bradley sees some truth in this argument, and that’s the reason his firm, Steadyhand, doesn’t use a large cap U.S. fund. “If somebody wants large cap U.S. funds, we think the S&P ETF would be just fine,” he says.

Though emerging markets may be the least efficient, active managers do not have a history of doing better than the benchmark. According to the SPIVA Scorecard year-end 2009, 89% of U.S. Emerging Market Funds failed to outperform the benchmark (S&P/IFC Composite) for a five-year period (see “Percent of active funds outperforming index: Q4 2009,” page 1). The active fund managers that do well in emerging markets or small cap sectors also come with higher fees that significantly cut into the performance in the long term.

Bradley agrees this is the challenge most foreign funds face, but points out there are a few lower- cost managers in this category, such as Mawer or his old shop Philips, Hager & North.

“For the most part, some of those ETFs in foreign or emerging markets aren’t as cheap as the basic ones. While it’s very easy to quickly get into high-cost foreign products, there are alternatives for sure.”

Case for active funds

But there are some investment needs that cannot be fully supported with ETFs alone. In the case of asset liability matching, combining ETFs with a bond appears to be the most effective approach.

When a client retires and needs a reliable stream of income, one strategy is to align his or her income liability with the right assets.

On the equity side, Seif says ETFs are just as good, if not better than a traditional equity, because they reduce the single-stock risk. Besides, the costs are lower so liabilities are better met.

However, on the fixed income side, using ETFs becomes a bit more challenging because the basket of bonds provides a constant duration, as is the case with mutual funds.

For liability matching, it’s more effective to have bond products with target duration.

With secured bonds, the returns and yield to maturity are predictable. Whereas with purchasing a fund that’s a universe of bonds, returns may go up or down depending on interest rates and the investor won’t know when par will be returned.

For this type of investing, Seif suggests Claymore’s Ladder Bond is a better alternative to the bond ETF or other products that represent a basket of bonds.

“It’s a better vehicle. It’s not the best. The best is still to go for an individual bond because you know you’re going to get maturity on those dates.”

Core and explore

According to Macdonald, behavioural issues also play a role in owning active funds or stock picking.

Passive ETFs are boring, he says, insofar as they provide average returns of all money managers, and investors generally like to distinguish themselves.

“We seem to think we can do better; we can pick a better manager. And there are managers that out-beat the market.”

With the core-and-explore approach, the asset mix is anchored down with passive ETFs. And it’s the core that does the bulk of the work to help investors attain financial goals. Once the goal is achieved, investors can allocate some of the surplus funds (non-earmarked) to invest a little more interestingly, whether in active funds or individual stocks.

“We’re getting back to where we shouldn’t be,” says Macdonald. “But if your goals are covered with the core, then you can afford to explore.”

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Rayann Huang is a Toronto-based financial writer.

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Rayann Huang