Good Morning
Even though the greatest movement of money from one investment vehicle to another (mutual funds to ETFs) in financial history is disrupting our business model it still amazes me that we, Financial Advisors, remain sanguine to the effects on our business model. I hear and participate in all the arguments concerning the pros and cons of active versus passive but PFGC believes we should be debating the pros and cons of which investment vehicle is best for our clients.
See the PFGC webinar on COIs:
Lets discuss.
Howard Marks of Oaktree Capital (an active manager) has written an insightful article on the use and risks of ETFs.(link https://www.oaktreecapital.
Mr. Marks vocalizes many of the concerns that active managers advocate as a reason not to buy an ETF. Basically investors punt on research on individual securities which may or may not lead to overevaluations because when you buy an ETF you buy all the securities with no distinction to valuation.
"Is it a good idea to invest with absolutely no regard for company fundamentals, security prices or portfolio weightings? Certainly not. But passive investing dispenses with this concern by counting on active investors to perform those functions."
I couldn't disagree more. As someone who believes that ETFs are a superior investment vehicle and I also believe that the record of human stock valuations are incredibly inconsistent. The saying, nobody beats the market, didn't come about because of active manager's over performance. It is just the opposite. On page 10 Mr. Marks points out that nobody beats the market and "on average all portfolios returns are average before taking into costs into account."
Mr. Marks goes on to say that "active management introduces considerations such as management fees, commissions and market impact associated with trading (ie: Capital Gains); and the human error that often lead investors to buy and sell more at the wrong time than at the right time."
The only aspect of active management with potential to offset the above negative is alpha, or personal skill. However, relatively few people have much of it."
Mr. Marks concludes; "For this reason, large numbers of active managers fail to beat the market and justify their fees. This isn't just my conclusion:if it weren't so, capital wouldn't be flowing from active funds to passive funds as it has been."
What Mr. Marks is saying is that we can argue all we want about active versus passive but the reality is that most people are voting with their feet and moving huge amounts of money into ETFs. (on pace to $1 trillion in 2018) There are many battles still to be fought but the war is already over.
PFGC believes the discussion should not be active versus passive but what are the characteristics of the different investment vehicles? If we assume all investment vehicles have flaws, and they all do, then which investment vehicles have less flaws than others? Trading costs, fees and tax inefficient trading lead to underperformance as well as a manager's failed investment calls.
Next Mr. Marks addresses what he calls "quantitative investing" which concentrates on dislocations between markets and securities but with "so much investing these days considers only the short run that I think there's great scope for superior active investors to make value-additive decisions concerning the long run". But unfortunately the numbers belie this rosy view of active long term performance. There is no empirical evidence that active management wins out over the long term. Quite the contrary about 85% of active managers underperform on a 3 year time horizon, 95% on a ten year and 100% over 15 years.
The attached report below (Mutual Funds Fees and Active Share) from New York State Attorney General is quite eye-opening on the effect of fees on overall performance. Many of the myths of active management are dispelled as after tax performance and fees are the major contributors to mutual fund underperformance.
Portfolio management expectations have changed because the measuring stick is no longer my mutual fund is in the top tier of it's sector performance. Translation, my mutual fund is performing less worse than other mutual funds in my sector but a lot worse than the overall market. No longer can we say, well all the funds in your portfolio are in Tier 1. So what if they all are underperforming. Relative performance is no longer an accepted measuring stick with index funds now mirroring their adopted indexes. We now must be aware that we are being judged on a different standard than in the past and we have to adapt.
Watch the PFGC webinar on Retention/Attrition Strategies which discusses the different investment vehicles in detail. https://attendee.
ETFs are the first step in a journey to AI driven tax efficient Direct Indexing Models (think Parametrics) as the end game. Computing power will disentangle portfolios to allow tax efficient portfolio management based upon an individual's risk profile. See PFGC's Big Data/AI webinar link: https://attendee.
Disruptive technologies don't care what we think. Disruptive technologies, given their name, is about replacing the existing business model and usually at a lower cost. One of the characteristics of disruptive technologies is that the new "way" is about 10% of the cost of the previous "way" of doing business. We certainly see that with mutual funds and ETFs. Actually the NYS AG report says that mutual funds are about 4.5X the cost of ETFs.
As Financial Advisors we need to think through a digital strategy and I am not talking about social media. I am referring to how we identify a path going forward where we are value add to the client because we have incorporated technology as a mainstay of our offering. Again, see PFGC's Big Data/AI webinar.
As we all know we have skipped spring this year and launched straight into summer and things tend to slow down substantially. We all need down time but use the down time to think through how you are going to build a model for the future so we all can maintain our lifestyles.
Good luck
Danny
