European markets have produced good returns over the last few months, and once again the debate has been intense between active managers and index funds or ETFs (Exchange Traded Funds). ETFs have quickly gained in popularity over the last decade as investors have become disillusioned by generally lacklustre investment returns from active managers. As a great believer in stock picking and being an active fund manager myself (a ‘dedicated investor’), here are some comments on the discussion and the reasons why we believe Europe is far better suited to an active approach.
The first ETF was launched in the late 80s but they did not become mainstream until the early 2000s. The ETF market is now thought to be as large as $1.5 trillion in size. ETFs, as the name implies, trade like shares offering exposure to many different asset classes including commodities, equities, bonds and property. Some active strategies are available on exchange but the area that has garnered the most interest from investors is that of passive, equity index tracking ETFs. This is hardly surprising when you consider that, historically, the returns of the average active manager have been less than that of their benchmark index.
Today’s markets are large, liquid and, with the fast and effective dissemination of market data, react more quickly than in the past. This, combined with greater competition, has made the task of picking stocks that will outperform the market more challenging. It differs from market to market but on average less than half of active managers outperform their benchmark indices. The main reason for underperformance is fees. For mutual funds active managers typically tend to charge between 1.0% and 1.5%. This means that through their active strategy managers must contribute at least 1.0% to 1.5% of alpha each year to produce a return equal to that of their benchmark. In contrast ETFs charge as little as 0.15%. This fee dispersion is meaningful, especially when you take into consideration the compounding effect this has over a number of years.
Given the facts it is easy to understand why ETFs have increased in popularity. However, this argument alone ignores other important benefits of active management.
First, there are parts of Europe that are not good investments. The next few years will be years of change and challenge in Europe, with low growth (but growth nevertheless) and higher taxes to reduce government debt. This environment will produce winners and losers (see the disastrous fall in renewable energy stocks as subsidies have been drastically reduced). The strong will get stronger and the weak will get weaker (or cease to exist). Index trackers do not distinguish between these two groups, while stock pickers actively do so.
Two sectors exemplify this point well, namely utilities and financials. The performance of the utility sector last year really serves to highlight that many of these companies have real problems. Investors have traditionally held utility stocks for their defensive nature, but a return of -11.7% in 2011 cannot be seen as defensive. The sector has a lot of debt (poor balance sheets Net debt to EBITDA is typically over 3x) and looks unlikely to be able to grow in any meaningful way over the next few years. In addition, many of the companies will likely face higher taxation, as we have already seen in Italy. Governments are seeking to increase tax receipts and utilities, given their lack of mobility, are likely targets. Again this is an area that index trackers are forced to hold, unlike stock pickers.
The financials sector still makes up around 20% of broad market indices. In general banks are still in a bad way balance sheets remain a mess and will take years to repair, and regulators will not allow them (thankfully) to perform the risky, leveraged activities that allowed them to achieve RoEs topping 20% in the past. This makes it likely that in ten years time Financials will form a smaller part of the market making them a less attractive holding over that period.
Of course, there will be periods when it is profitable to hold some financial or utility stocks on a short term basis, and ideally stock pickers can identify these periods and tactically add these stocks to their portfolios.
Second, the structure of some ETFs and the relatively immature regulation surrounding ETFs is concerning. A number of these passive funds have proven that it is difficult to track an index exactly, with the underlying constituents’ weights changing constantly. This tracking error is not always clear on first inspection. Transparency is also poor and the restrictions on collateral posted for synthetic ETFs (an investment that mimics the behavior of an exchange-traded fund through the use of derivatives such as swaps) are loose. Collateral refers to the assets posted as security in case the derivative provider goes bust. Current regulations allow a wide range of assets to be posted as collateral, with little consideration for the correlation with the underlying ETF, backing a US equity ETF with French government bonds for example. This is fine in normal market conditions but if we were to see an extreme liquidity squeeze (which unfortunately seems more probable in today’s world) this could be a major problem. Compare this to an active manager who buys ordinary shares that are then safely held by a custodian, segregated from other assets. An investor knows what they own and where it is. One of the lessons learned from the latest financial crisis is that simplicity can be extremely valuable in times of stress.
Proponents of ETFs will also suggest they are lower risk because of their diversification benefits. This is mistaken. If you construct a 50 stock portfolio with a good spread of sector, geographic and factor exposure the risk benefits of adding another 550 stocks are marginal. Indeed in 2008, when the correlation of all risk assets converged toward one, this diversification meant nothing, the real risk was in banks, and whether you held them or not. Index tracking ETFs were forced to hold financials (c.25%) while active managers still had the choice.
Finally, some stock pickers have proven they are up to the task. Despite active managers having underperformed the market in general (and their ETF peers), there are a number of managers that over the long term have added value for their clients. For those who are able to familiarise themselves with the approach of these funds, the pragmatism of active managers over varying market conditions can prove very rewarding.
Tim Stevenson is Henderson Global Investors Pan European fund manager. Henderson Global Investors is represented in Israel by Meitav Investment House.
Published by Globes, Israel business news - www.globes-online.com - on April 19, 2012
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