Why one issue with passive funds is their investors

Every time an investor buys a passive investment, such as an exchange-traded fund, they are – whether they realise it or not – making an important trade-off between cost and expertise



Andrew Lyddon
Fund Manager, Equity Value

Earlier this year, we put the case that passive funds, like sausages, are only as good as their ingredients.

In a similar vein, just as sausages tend to taste nicer and do you less harm if you cook them first, to get the best out of a passive investment, such as an exchange-traded fund, people need to use them appropriately.

Unfortunately, there is  plenty of evidence to suggest they do not.

Take, for example, a study of the investment portfolios and trading habits of more than 1,000 non-professional users of a big German brokerage between 2005 and 2010.

The large amount of data involved in this project – brought to our attention by our friends at Empirical Research Partners – enabled the researchers to do some detailed work on the comparative returns made on different types of investment.

ETFs tended to underperform active investments 

Arguably one of the more interesting aspects of this exercise was the way the researchers were able to break down the returns the investors actually achieved and then compare those with what they might have seen if they had done things differently or indeed done nothing at all.

And it turns out the ETF portions of the portfolios tended to underperform the more active investments – apparently for two main reasons.

As it happens, these two principal drags on ETF performance had nothing to do with the investments themselves but the way they were used by the investors.

Reason 1

By far the biggest was that people were very bad at picking when to buy into and sell up their ETF investments.

Reason 2

To a lesser degree, the research suggested, they were also bad at picking the best ETFs to buy in the first place.

As an illustration, the research suggested investors should have looked to stick with one broad market index rather than trading in and out of different ETFs.

Thus, for example, if they had stayed invested in the MSCI World index instead of chopping and changing, they would have been better off to the tune of about 100 basis points a year.

Refraining from trying to ‘time the market’ would also have added to annual returns.

Attempts to time the market and any resulting deterioration in performance are, of course, hardly the sole preserve of passive-oriented investors.

That is just one reason why a more long-term approach to investing – something that is integral to a value strategy – can be so helpful to all investors, active and passive.

There is, however, no escaping the fact that, every time an investor buys an ETF, they are – whether they realise it or not – making an important trade-off.

When buying an ETF you are making a trade-off

In exchange for paying a much lower fee than the average actively-managed fund, they are taking on a lot of the tasks an active fund manager would otherwise perform, including judging what securities to buy and sell – and when.

That is as it should be and a level of flexibility every investor should be able to take advantage of if they wish.

Nevertheless, if investors are using ETFs to escape the higher fees and/or underperformance that can, without question, be found within the active fund management arena, it would be unfortunate if they then repeated some of the key investment mistakes that can lead to disappointing performance and so offset some or all of the fee benefit of passive funds.

In other words, if the potential result of buying and selling passive funds is a drag on performance that is greater than any saving on management fees, this is something investors need to factor into their thinking –unless they ultimately want to find themselves looking at their portfolios and feeling as queasy as if they had just eaten an uncooked sausage.

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Andrew Lyddon
Fund Manager, Equity Value


The Value Perspective
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