Robin Powell: Important warning on new active ETFs

“First they ignore you, then they laugh at you, then they fight you, then you win.”

Whoever said or wrote these wise words (apparently it wasn’t Mahatma Gandhi), they could well have been talking about the triumph of passive investing.

I’ve been writing about this historical inevitability for 13 years, and I’m pleased to report that the ignoring and laughing phases are finally over.

UK fund houses are haemorrhaging assets and starting to hurt. Abrdn announced in January that it was cutting 500 jobs; since then, other firms have announced they’re reviewing costs, all of them citing the pressure of competing with low-cost index funds.

Pull up a ringside seat: we’re in for quite a fight in ETF land. But there will be only one winner

After years of complacency, the most diehard apologists of active management have at last woken up to the existential threat the industry faces. Even former head of research at Hargreaves Lansdown and Neil Woodford cheerleader Mark Dampier has now admitted he underestimated the challenge posed by passive funds.

“I think many of us were fooled into thinking they weren’t that important,” Dampier confessed in a recent Money Marketing column, although he couldn’t resist a dig at what he called “passive smugness”, bringing to mind the words ‘pot’, ‘kettle’ and ‘black’.

Phase three

So, we’re now in phase three — the fight itself — and you need look only at what’s happening in exchange-traded funds (ETFs) for proof.

So far this year, Ark Invest, BlackRock, BNP Paribas and JPMorgan have all rolled out actively managed ETFs for European investors, and many other active managers will follow suit. According to the consultancy Blackwater, 92% of European fund managers plan to either launch, or consider launching, ETFs within the next two years.

I do see a role for active ETFs of the systematic, or rules-based, variety. But traditional active stockpicking is a busted flush

How quickly things have changed. For years, fund management companies sneered at ETFs, but they suddenly seem to have become their biggest fans.

Why? The main reason is obvious. They’ve seen huge inflows into active ETFs in countries including Australia, Canada, South Korea and the US, and they now want a slice of the action (or, more to the point, the fees) themselves.

But there’s another reason for active managers to embrace ETFs, and that’s to wipe clean the performance slate.

If you run a mutual fund with a long record of lagging the market, washing away that underperformance by relaunching it as an ETF is enormously appealing.

Some indexing advocates have a downer on ETFs. One reason is the option for intra-day trading, which they feel encourages people to trade them. I get their point but, if you have the discipline to hold your passively managed ETF for a very long time, I don’t see an issue.

For years, fund management companies sneered at ETFs, but they suddenly seem to have become their biggest fans

The problem, then, with active ETFs is not that they’re ETFs but that they’re active. As investment author William Bernstein once put it, the ETF is just a wrapper, and launching an active ETF is like putting bad fish in a pink wrapper instead of a blue one. It won’t mask the smell.

The hype around active ETFs, in other words, is just a distraction from the bigger issue — the inherent inferiority of active funds. (I’m not stating an opinion, incidentally, but a mathematical fact.)

As US investor Jack Bogle liked to remind us: “The net return is the gross return minus the cost of playing the game.” Active ETFs, though cheaper than other active funds, are still much more expensive than passive ETFs. So, the average active ETF investor has to underperform the average passive ETF investor; it’s simple arithmetic.

Demand for active has been strong worldwide, and I expect that to continue. But for how long?

The problem, then, with active ETFs is not that they’re ETFs but that they’re active

I do see a role for active ETFs of the systematic, or rules-based, variety; they have a good chance of producing excess returns for investors with sufficient patience.

But traditional active stockpicking is a busted flush and, unless firms reduce their fees dramatically, a change of wrapper won’t change its fortunes.

So, pull up a ringside seat: we’re in for quite a fight in ETF land. But there will be only one winner.

Robin Powell is editor of The Evidence-Based Investor

This article featured in the May 2024 edition of Money Marketing. 

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