This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Michael McClary, chief investment officer of Akron, Ohio-based TOPS ETF Portfolios.
For more than 75 years, traditional active management has been the default option for investors. From the 1920s and ’30s, when direct stock and bond selection was the only option, through the Investment Company Act of 1940, investors have defaulted to traditional active management.
Active management has had a strong emotional hold on investors. The idea that investors can pay more money to someone with significant education and experience to provide better returns just makes sense.
One popular American saying is, “you get what you pay for.” In the case of investing, the mantra has been to pay more for more return.
Even though index investments were first mainstreamed in the 1970s and ’80s, the active management head start has been very strong. It has taken four decades for index investments to finally dethrone actively managed funds as the default option for investors. And while the transition is still occurring, the trajectory and direction are not reversing.
I oversee several billion dollars in active management, as well as our $5 billion in ETF assets. Much of the actively managed assets are legacy positions accumulated by investors over the 54-year history of our firm.
I do not dislike active management. On the contrary, I would love for active management to deliver extra return as promulgated. However, I recognize we are likely to have fewer assets in active management 10 years from now than we have today, as active management is no longer the default option for investors.
In this article, I will address issues affecting the transition of assets to index investments.
Reason Leads To Conclusions, Emotion Leads To Action
Donald Calne, a leading neurologist, is credited with saying “The essential difference between emotion and reason is that emotion leads to action, while reason leads to conclusions.”
The logic behind index investing is strong, and I would argue, conclusive. In the following chart, the key results from the most recent S&P Index Versus Active (SPIVA) report are shown.
For a larger view, please click on the image above.
Sources: S&P Dow Jones Indices LLC. SPIVA U.S. Scorecard Year-End 2016. The S&P 500 is a capitalization-weighted benchmark that tracks broad-based changes in the U.S. stock market. The S&P MidCap 400® provides investors with a benchmark for midsize companies. The index, which is distinct from the large-cap S&P 500®, measures the performance of midsize companies, reflecting the distinctive risk and return characteristics of this market segment. The S&P SmallCap 600® measures the small-cap segment of the U.S. equity market. The index is designed to track companies that meet specific inclusion criteria to ensure they are liquid and financially viable. The S&P 700 measures the non-U.S. component of the global equity market through an index that is designed to be highly liquid and efficient to replicate. The index covers all regions included in the S&P Global 1200 except for the U.S., which is represented by the S&P 500®. The Barclay’s Long Term Government/Credit Index includes publicly issued U.S. Treasury debt, U.S. government agency debt, taxable debt issued by U.S. states, territories and their political subdivisions, debt issued by U.S. and non-U.S. corporations, non-U.S. government debt and supranational debt. One cannot invest directly in an index. Indices are unmanaged and do not incur fees.,span>
Specifically, the table shows the percentage of actively managed mutual funds that have underperformed their benchmark indexes over varying time periods. Every six months, S&P compares active managers to indexes. These reports can be accessed here as well.
Bringing up the SPIVA report to active managers is a sore subject. After reviewing the information, along with the accompanying S&P Persistency Scorecard, any logical investors would have to conclude indexes may provide a better statistical chance for success.
However, investors need to make the emotional decision to sell their active funds and buy indexes. While logic can contribute to emotion, other emotional factors can overpower logic. Just ask any teenager about the last 10 decisions they have made.
To make the emotional decision harder, some active managers have tried to confuse the logic.
Studies have been released by active managers that effectively show, "If you screen the returns for only Tuesdays in the fall on days when it isn't sunny and close your left eye, active funds outperform."
Sure, there will be some funds that outperform in each year. However, the S&P Persistency Scorecard shows almost no funds consistently outperform over time. Likewise, the deck is stacked heavily against the odds for the average active manager to outperform indexes over time. Further, there is no sure-fire way to decide ahead of time which manager will be above average.
ERISA & The DOL Rule
The fiduciary-driven 401(k) world is a fertile setting for index management to grow. When advisors are fiduciaries, they are forced to make the right decision for the investor.
Due in significant part to that fiduciary status, indexes are grabbing market share in the 401(k) world like Amazon is gathering shoppers. Even top-performing active funds are being replaced with lower-cost index investments in 401(k)s.
The DOL Fiduciary Rule has transitioned the index momentum from the 401(k) world to the individual investor marketplace. While portions of the rule have been delayed, the fiduciary mindset is already in place, and it is not going to ratchet back.
Investors now will ask their advisor, “Why did you decide to spend more of my money on that active fund?” Likewise, the advisor is supposed to now have a satisfactory answer. We all know it can’t just be a star rating or recent performance numbers.
Losing Default Status Doesn’t = Extinction
Fear not: Active management is not going away as a choice for investors. In the 1970s, the default family sedan was a gas guzzler the size of a boat. Now, the two most popular sedans in America are the Honda Accord and the Toyota Camry. Sure, drivers can still buy a big gas guzzler. However, it is done as an active choice, not a default selection for lack of choice.
Active managers shouldn't be surprised. They had to expect investors would recognize they were putting on weight and eventually ask to see how many calories were in the meal.
I would encourage those active managers who argue that a healthy balanced diet (diversified portfolio of ETFs) is bad for you to rethink their messaging. Instead, focus on why certain investors may want to complement core ETF exposure by taking a risk to outperform. Las Vegas does just fine luring willing gamblers, even if the majority loses. No need to try and dispute the published odds.
Beware Scare Tactics
When someone is losing a customer, and watching business shrink, a customary reaction is to try and scare customers away from the new option.
In the area by our office, there was only one car-wash option for several years. It was a “no touch” option that cost $12-$15 a wash, and never seemed to really get my car very clean. About two years ago, a new car wash opened that allowed unlimited car washes for about $30 a month.
The new car wash has been wildly successful, for easily recognizable reasons. The reaction from the owner of the old car wash was to launch a smear campaign, highlighting that his no-touch car wash was worth the money, because the new car wash will scratch your car (even though his own research shows pretty much every car gets scratched somehow anyway).
The car-wash owner’s reaction is like the articles I read that try to scare investors about indexes and ETFs. One even referred to ETFs as “weapons of mass destruction.” As ETFs continue to gain market share, the fear is indexes will ruin investing.
While I disagree with this concept on many levels, it is easy to rebut simply on timing and degree. It will take a very long time for passive investing to have a marked impact on results. According to Vanguard, only about 15% of the global equity market is indexed. This leaves 85% invested in some type of individual stock selection.
Obviously, 85% is more than plenty to punish companies that do poorly, and reward companies that do well. Likewise, if indexes are really creating problems, active managers should quietly try to arbitrage it.
Often, ETFs get bashed simply for having innovative ideas. I was interested to see so many people write negative articles when a bank-loan ETF came out years ago, even though far more bank loan assets were already held in actively managed funds with daily liquidity.
While actively managed mutual funds had essentially the same issues, and didn’t have some of the ETF safeguards, they were given a pass in articles highlighting ETF issues.
The most common argument I hear about why advisors don’t switch to index investing is, “What about the relationship I’ve had with XYZ funds for 20 years?”
While relationships are important, I don’t believe investors want to hear that their advisor bet their entire life savings on a more expensive option with a small group of funds because their golf buddy works there. Investors often only get one chance to build up retirement assets.
XYZ fund company may have gotten nearly 100% of clients’ assets in the past, but they’re going to have to make ends meet with 50% or less in the future. Trust me, they’ll still be OK.
Index Investing Doesn’t = Totally Passive
Some investors have yet to make the change to index investing because they think it is “passive.”
I hate the word “passive” to describe index investing. Many of the professionals I know who run index-based investments work very hard, and there are actual necessary job functions involved with the concept, such as the index provider and the portfolio manager of an ETF. Indexes and ETFs don’t just happen with no effort and by nature they are not fully passive.
Likewise, much of the added value has simply moved to the portfolio level. Instead of advisors focusing on underlying funds adding value, the value is now created in the asset allocation decisions using indexes.
We call TOPS, our primary investment strategy, “A Strategic Approach to Active Indexing™.” We put in thousands of hours of total time each year researching and managing our portfolios. Likewise, we adjust allocations and hire and fire ETF providers consistently.
Passive investing is simply a misconstrued word in this context—not much different than the ills of the term “smart beta.”
It Will Be OK, Just Different
Change is disconcerting for almost everyone. However, the only constant is change, to paraphrase Heraclitus. In the case of index investing, the long-term results of the change are good for investors as well.
It is my belief that nearly all investors should have at least 50% of their money in indexes, and most investors should have all their portfolio in indexes. When I started managing ETF portfolios, there were less than 100 ETFs available. Now, there are more than 2,000. Likewise, there are now famously more indexes than stocks!
Instead of picking stocks, or trying to pick other folks who will pick the right stocks, we will continue to primarily add value for our investors by managing well-diversified portfolios of ETFs.
ValMark Advisers Inc. is the manager of the TOPS Portfolios of ETFs. ValMark started managing "TOPS" separately managed accounts of ETFs in 2002. The firm manages more than $5.1 billion in ETFs for retail and institutional clients in multiple investment products. Email: [email protected]; phone: 800-765-5201. For a complete list of relevant disclosures, please click here.